Four Horsemen of the Apocalypse

Joseph W. Bartlett, Founder of VC

The view from this corner, based on close to 40 years in the business, is that the commercial, industrial and financial sector of the economy, known variously as "emerging growth/ venture capital/entrepreneur-driven," has never been remotely as robust as it is today. The amount of professionally managed money in the United States invested in companies we will group under the heading of "venture-backed" is several orders of magnitude larger than it has ever been. So-called angel investing, investment in venture capital by high net worth individuals, is also reaching unparalleled levels. Despite the so-called NASDAQ meltdown, long term investors generally favor of tech stocks; after all, the NASDAQ index is significantly higher than it was a year or so ago. The casualties are limited to those investors who invested at the delirious peaks. And, the phenomenon has globalized.

The short hand explanation for what is going on, I believe, can be captured from the title of this column, "The Four Horseman of the Apocalypse." In this case we are not talking about pestilence, famine, etc., but ATT, Xerox, Polaroid and Kodak. These are living (at least for now) witnesses to one of the foundational theses of the new economy … that companies must innovate or die. And, the model for innovation currently in fashion, in fact in fashion again after a lapse of about twenty-some odd years, is called corporate venturing. The Four Horseman of the Apocalypse, unfortunately, are examples of what happens when a highly innovative company loses its technological edge. As management of the multi-nationals around the world look in the rear view mirror and see the Four Horsemen, their response has been dramatically to revive interest and activity in corporate venturing.

A brief history of corporate venturing is set out in a thoughtful book, The Venture Capital Cycle, by Josh Lerner and Paul Gompers. Perhaps the most celebrated pioneer in this genre was Lockheed and its celebrated 'Skunk Works,' followed by (ironically) Xerox and the Palo Alto Research Center (PARC) … where, as all are aware, Steve Jobs got the inspiration for Apple Computer. A number of companies established affiliated venture capital funds and/or invested as limited partners in free standing funds in the `60s, `70s and early `80s, the theory being that in-house R&D had its limits and the energy and talent of independently minded entrepreneurs could be tapped by investing in minority positions in their companies, either directly or through an intermediate pooled investment vehicle. Some of the multi-nationals continued to follow this practice through the down turn in the late '80s and early '90s, most notably the major pharmaceutical companies (aka Big Pharma), which are obviously dependent for their survival on innovation; a therapeutic or diagnostic that loses its patent protection must be replaced by a new proprietary drugs equally, or the company is on its way out of business. However, many of the major players, ATT and Xerox among them, appear to have relaxed their corporate venturing initiatives during this period, particularly since the financial returns from venture-backed companies were disappointing following the 1987 market crash. And, some of the problems inherent in establishing an affiliated venture fund were becoming difficult to solve.

While it is always problematical to track specific cause and effect, it seems quite plausible to conclude that the fate of the Four Horsemen, dismal as it appears today, can be directly traced to management's lack of effort in the corporate venturing arena over the last 15 or so years. I suggest, indeed, such that is the conclusion being drawn by managements of companies like Intel, Hewlett Packard, MicroSoft, Cisco, etc., all of whom are in the corporate venturing sector in spades, along with their overseas counterparts, Deutsche Telekom, SoftBank, etc. Corporate venturing in a word, is back in vogue, which triggers the following thoughts concerning the problems we briefly mentioned and suggested ways to solve them.

Let us assume a multi-national corporation (and, to make it a little harder, one based outside the United States, but with extensive operations in the U.S.), decides that it needs to get much more in tune with fast breaking developments in science and technology, particularly the versions being developed in U.S. laboratories and teaching hospitals. The multi-national has, broadly speaking, three alternatives to consider … (a) a direct investment program, run either from outposts in the U.S. or from headquarters in, say, France or Italy by which it sprinkles investment capital in early stage firms as a strategic investor; (b) investing as a limited partner in a free standing U.S. based venture fund controlled by others; and/or (c) establishing or sponsoring the creation of a U.S. based fund in which it either provides one hundred percent of the investment capital or is the dominant lead investor. In each of these three scenarios (and particularly in the latter two), the thought is that the investment managers will be a combination of in-house personnel and U.S. residents with prior experience in venture investing. The first program entails what is called direct investing and the second and third involve investing through an intermediary. Obviously, a given multi-national may try all three strategies, either sequentially or all at once.

The notion is that structuring an investment program in this way is a win-win proposition. The multi-national itself may generate interesting items of science and technology which can be either developed in-house or seconded to a venture fund which will exploit and incubate the intellectual property in an entrepreneur-dominated company. If the latter course is elected, the notion is that entrepreneurs are often nimbler, more energetic and, indeed, driven than in-house personnel and, therefore, new vistas open up.

The first problem encountered by the multi-national is often noted - cultural. There is no particular reason for me to add to the literature on that subject, except to identify specific subsets of the tension between the founder/entrepreneur of a portfolio company and the executives of the multi-national. And, the list of issues starts with economic differences between the executives of the host organization and the managers of either a private equity fund or a direct investment program. For this purpose, I will focus on alternative three, being a venture capital fund which is funded either in large part or in whole by the host organization and managed by both insiders (who have been seconded to the managing entity of the fund) and recruits from the outside world. For simplicity's sake, I will call this vehicle a "private label" fund.

The most serious problem has to do with the economics of venture capital. If, say, a senior vice president of the host organization, enjoying a salary the French franc equivalent of $350,000 a year plus benefits, is transferred to the general partner of a $300 million venture capital fund, the pecking order within the host company can change significantly. One need not be a rocket scientist to understand that, if the $300 million is invested successfully and the individual manager has a significant portion of the so-called "carried" or "promoted" interest in profits of the fund (typically 20% of profits distributed amongst the three or four professional managers), the vice president may wind up in relatively short order significantly richer than the chief executive of the multi-national company. To make matters worse, the seconded manager, having been given a free pass to manage a venture capital fund, is then in a position (either with his/her colleagues or on his/her own) to take the fund's "track record" (assuming success) and go out independently to raise, say, $500 million. There is an enormous amount capital seeking competent managers in this space; simply by virtue of being transferred from, say, the treasurer's office in the corporate development division to managing the allied venture fund, the lucky individual becomes a multi-millionaire while his/her colleagues back at the ranch, so to speak, are still working for wages.. perhaps generous salaries and benefits including stock options, but nonetheless wages.

This possibility, of course, is well known in advance when a multi-national goes to organize a venture fund and it simply must be faced. There is no solution. It is possible, of course, to avoid sharing the 'promoted' interests with the managers of a venture fund; but that system (which is seen very rarely) runs counter to the entire culture of the industry. Moreover, the conventional wisdom, which is about all the wisdom there is on the point, is to the effect that talented people will not perform up to their capacities in managing capital unless they are compensated with a "piece of the action," indeed a 'piece of the action' which is competitive with other venture funds. The executive transferred from the host multi-national simply reaps the benefits created by that enduring notion. Adding insult to injury, in the typical private label fund structure, the favored executive/fund manager often retains employment status with the host for purposes of medical and retirement benefits, stock option participation, etc.; he/she has a his or her "cake and eats it too." This can be, of course, an enormous source of resentment inside the mutli-national's organization.

Secondly, in today's environment there is an enormous amount of liquidity in the system chasing good deals. Therefore, it is very important for an investor, whether a direct investor or working through a private label venture fund, to move quickly. There are a lot of deals that will wait around for the investor to make up its mind but those are usually the deals one is not terribly interested in funding. The good deals, if not grabbed by investor A, in all likelihood will be snapped up by investor B. Accordingly, the managers of a private label fund usually negotiate long and hard for a significant quantum of independence, arguing they should be given leeway to make investments as they see fit, reporting after the fact to their host. Moreover, and in like vein, they resist stoutly the notion that the CEO and board of the host have the power to make changes in fund management personnel. They view themselves, in essence, as independent contractors rather than employees, and argue that such status is necessitated by the way the system works... 'Jack be nimble, Jack be quick.' The problem for the CEO and board of the multi-national is not that they necessarily disagree with the idea of delegating authority and subscribing to the 'Jack be nimble' theory, rather, however, their problem stems from the fact that the private label fund is inexorably identified, either expressly or implicitly, with the multi-national's brand. Usually, it is widely known that there is a nexus between the multi-national firm and the fund; thus, if some bizarre mistake is made by the portfolio managers, it is only natural for the multi-national to feel its brand has been negatively impacted. Accordingly, the host seeks significant controls, at least to the extent of being able to fire an individual manager if he or she is fouling up in ways that not only threaten financial returns but might have a ripple effect on the host company itself. As a result, there is a good deal of pushing and hauling between the independently-minded managers (including those who, immediately previously, had been loyal employees of the host) and the board and senior management of the multi-national firm. And the outcomes vary widely, ranging from the ability in multi-national (a) to fire individual managers; (b) to replace the entire management and continue in business; (c) to call off the game and liquidate the fund; and/or(d) to curtail new investments.

The third major issue has to do with the sticky issue of conflicts of interest. Assume, for example, the multi-national strategic partner is the dominant, but not the only, investor in a private label venture fund. Assume that a promising piece of technology surfaces and is first spotted by the Hong Kong office of the multi-national. Is there an obligation to share that investment opportunity, or indeed to concede the investment opportunity, to the fund? Or may the strategic investor, through its Hong Kong office's internal processes, simply conclude that the deal is too good to pass up and buy 100% of the company. Is that a violation of the U.S. doctrines of "fiduciary duty" and "corporate opportunity?" Assume, by the same token, that when it comes time to harvest the opportunity (which is now, in our new hypothetical, lodged in the portfolio of the private label fund), the preferred exit is to put the company on the block and sell it. Is there any obligation in the managers of the fund, some of whom may still be, technically, employees of the multi-national, to favor the multi-national in the bidding process? Substantially the same issue crops up with respect to co-investment rights. Assume again a private label fund with multiple limited partners. May the fund managers, out of loyalty to the alpha male in the piece (i.e., the multi-national dominant LP), favor their benefactor, with preferential co-investment rights? These issues are thorny. There is no perfect solution and it usually requires a certain amount of elegant wordsmithing in the organizational documents in order to pacify all sides. Typically, the language is precatory versus obligatory, stating in effect that the dominant partner will use its "best efforts" to adjust the allocation of opportunities "fairly and equitably," but that it has no obligation to do so... a meaning that, if it does seem something that is particularly tasty and appropriate for its own portfolio, it has the ability to snatch it away from the fund.

A final issue, the converse of the above hypothetical, has to do with the incentive for minority LPs to co-invest in a private label fund that is dominated by our hypothetical multi-national. The reason most (if not all) of the LPs become fund investors in the first place is that they believe a multi-national will see a wide and broad deal stream, perhaps globally sourced, that otherwise would not come to the attention of a small cadre of fund managers. All parties to the investment process will profit accordingly from the relationship. This requires those in charge of structuring the fund to solve another problem, which is now attacked with some success in corporate venturing situations. That is, assume that multi-national A with offices around the world is in a position to see an attractive deal stream. It does so, of course, through individuals, i.e., its lieutenants stationed in its remote offices... Hong Kong, Singapore, Warsaw, etc. It is one thing for the senior management to urge the people on the front lines to forward promising deals to the managers of the fund. Given that most people work twenty-four/seven, these days, that inspirational language is usually not enough to get the job done. Accordingly, the hypothetical multi-national often sets up a so-called "side-by-side fund," a fund which invests in lock step and pari passu with the main partnership but which is not subjected to a "promote" or "carried" interests in profits or a management fee. That fund is open up to key executives in the multi-national's system as a method for motivating each of them to consider themselves part of the investment team and to make an extra effort to canvass the landscape for promising deals.

One of the interesting consequences of that phenomenon was exposed, to me anyway, in a recent conversation with Ralph Carmichael. Ralph and his organization manage private equity funds and he was discussing a new fund he was in the process of organizing. He mentioned that he was planning on applying for a license for the fund to function as an SBIC. I routinely remarked, "Oh sure, the participating securities program, I assume." I had in mind the highly successful program stimulated by thinking from Alan Patricof and Pat Cloherty in the early 90s which allows the SBA to license SBICs and provide capital in the form of preferred stock versus debentures, the idea being that the preferred stock nature of the investment would in turn allow the licensees to invest long term in, for example, venture capital opportunities where the chances of cash flow in the early stages are remote and therefore, the contribution of capital in the form of debt inappropriate.

I simply assumed Carmichael had that program in mind like 450 (or so) private equity funds which have taken advantage of government capital structured as equity and in turn have made equity investments.

Carmichael responded that, to the contrary, he was planning on applying under the traditional debenture program. This brought back memories. When I started in this business back in the very early 60s, several of the capital providers were in fact SBICs and I think particularly of Memorial Drive Trust which drew down capital in the form of debt and in turn invested debt and equity in venture opportunities. The reason that Memorial Drive and others could function were two-fold. First, since there were a lot more opportunities than there were professional VCs, the venture capitalists could follow the definition of early stage which was passed on to me by my mentor in this business, Bill Elfers: "Early stage means cash flow breakeven" meaning in turn that the VCs would pick firms which had ability to service some debt, and make a bundled investment of debt and equity in the firm.

Secondly was the fact that interest rates were so low that the debt burden was not severe. Since the SBIC did not pay the government much in the way of an interest coupon, it could afford to re-lend the debt portion of the investment to a portfolio company on terms the company could afford, even though it was still in its immature stage.

And, of course, that is the opportunity Carmichael sees with, say, a mezzanine fund that invests in later stage venture opportunities or in buyouts. Debt is now a realistic element of the financial package because interest rates have returned to the levels which existed when Memorial Drive Trust was organized. As they say, deja vu all over again.