Venture Capital, High-Tech Industries, and the New Millennium
Transnational Research Associates
Art Madsen, M.Ed.
There are a number of astonishing features of the ever-evolving Venture Capital industry, both in the United States and overseas, all of which are deserving of in-depth analysis. This survey intends to examine the forces and characteristics of the high-tech venture capital industry as it is presently evolving, and will do so by concentrating on three primary developmental factors which have been identified in the existing literature as being crucial to an understanding of the dynamics underway.
Firstly, the phenomenal growth of this financial 'reality', which is continuing to fuel new firms on an unprecedented scale in several manufacturing and high-tech sectors, has drawn the attention of some of the world's leading economists, development theorists and monetary experts. Indeed, they, as well as increasing thousands of astute investors, are beginning to scrutinize the many fascinating characteristics of this world of risk, profit and productivity far more frequently than in the days of classic venture capitalism, pioneered by Harvard's General George Doriot and then President of Boston's Federal Reserve Bank, Ralph Flanders, in 1946. (Bygrave and Timmons 1992) The attention of modern financiers seems riveted on the dynamics of the venture capital industry largely because it is in such a growth-period of foment and transition.
Secondly, while the growth of capital made available is attracting attention, so too is the direction which the industry seems to be taking. The energy sector is being abandoned and high-tech is being invariably favored, with an emphasis on bio-technology, semi-conductors and the computer industry. This report, therefore, will examine how the direction of venture capital is changing, and will explore what new high-tech sectors are being prominently encouraged. Closer examination of sub-sectors within the still blossoming high-tech industry, which show particular promise, will also be included.
Thirdly, and perhaps equally importantly, the role of venture capital, in relation to entrepreneurs, investors, and investment bankers, will be examined in this report. Trends, becoming increasingly complex, tend now to involve government and public stock or equity markets, in addition to the traditional players. This is particularly the case when R&D initiatives culminate in a high-tech innovation ultimately funded, before or during the commercialization phase, by venture capitalists.
The commonly accepted misconception that venture capital spawns new industries will be explored and it will be shown that in intermediate stages of growth such capital is usually made available, not in the start-up phase.
Due to their importance in understanding the nature of funding blossoming (or even marginally performing) ventures, the three parameters briefly itemized above will form the substance and thrust of the present analysis of high-tech venture capital as this dynamic 'financial vehicle' moves into the 21st century, along with the very technologies it fosters. Indeed, growth, direction, and role of venture capital in the North American and European systems constitute a worthy focus for this report which intends to situate and clarify these generally encouraging characteristics within the high-tech industries of Massachusetts, California, New York and Connecticut, plus those of Germany, France and the U.K., representing over 75% of world-wide venture capital markets at this juncture. (Bygrave and Timmons 1992) Because this share-of-the-pie is expected to shift dramatically in the years ahead, the U.S. and Europe, in order to avoid being relegated to the status of second-rank economic powers, will have to rekindle their efforts and flame new fires of innovation. Fortunately, most specialists feel that it is clearly within the realm of the possible to achieve stability for the West and, simultaneously, expansion for the Far East and the Third World.
It must be asserted that, with 60 Billion dollars per year in American capital venture markets alone being made available in high-tech sectors (Bygrave 1997), and many tens of billions more in Europe, the growth, direction and role of venture capital, and its founder-backers, are truly topics of interest to contemporary managers in industry, academia, technology and the biological sciences. Not only has the attention shifted from energy to the high-tech sector in the United States, but also in Europe where a similar degree of emphasis on computer technology is now being concentrated in Germany, France and the U.K. where investors and venture capitalists seem to be leaning toward state-of-the art developments in hard-drive technology, bio-technology and telecommunications.
Following an assessment of the foregoing factors, all of which influence the VC industry, and hence high-tech growth everywhere, a predictive glance into the new millennium will enable the reader to glimpse what may well be in store for venture capitalists and high-tech initiatives in the decades to come. These prognostications will be based on several articles which allude directly to the immediate and medium-term future of this fast-growth economic sector where profits and risks are both very much a part of the equation.
II. Growth of the High Tech Venture Capital Industry in the Last Two Decades
Keeping in mind that the US model of venture capital is one that is universally admired throughout the world, especially for its abilities to promote new, successful and productive companies of varying sizes, a brief review of venture firm growth trends worldwide might prove enlightening. From 1986 through 1990, in billions of dollars of available capital (in certain sectors which remain constant), the following figures for five VC-conscious geographic sectors are provided from the Asian Venture Capital Journal, as quoted by and excerpted from Bygrave and Timmons (1992):
Geographic Location 1986 1990 (est.) USA 24.10 35.00 Europe 08.95 29.00 Japan 03.26 10.00 Canada 01.30 03.00 Korea 00.45 01.00
Whether growth indicated on Figure 1, above, is assignable to the high-tech sector alone is not critical, since these figures demonstrate the 'overall magnitude' of the increase as a whole. For example, note the growth, in just four years, of Europe's venture capital funding. Europe's growth seems largely to have been realized by the spontaneous interaction of entrepreneurs and venture capitalists in the U.K. and Germany. Japan, as well, literally tripled its initial interest in financing of fledgling firms through such venture initiatives. Because banking regulations are quite strict in Europe and the USA (ceilings exist to prevent usurious interest rates on loans of any type), VC firms are positioned to take risks and reap benefits far beyond the proportions or levels permitted highly regulated banking institutions. So, unconstrained growth of venture capital is being fueled by new innovations needing financing at post-seed-capital stages of development; but it is also needed to create new jobs, products and services, 'unfinanceable' by banks. In fact, there is a symbiotic relationship among venture capital, creativity and need.
Growth is also being fueled by increasing use of high technology equipment in the military sector, the civilian computer industry, and the sub-specialty sectors of bio-technology and telecommunications. The investors served by the typical VC firm which acts as intermediary between them and the entrepreneur are also, in all of these high tech fields, tempted by profits and appealing returns on investment (ROI). If a firm profits, the venture capitalist may receive 20 to 30% of the profit, while the investors receive 70 to 80%. (Zider 1998) The amounts of capital initially put forward may be considerable, ranging upwards to 20 or 30 million dollar portfolios (often including a number of different firms being supported) with profits in the area of between 15 and 30% per year (or higher), a phenomenal sum when compounded by other earning factors (such as standard salaries and perks for all involved in the VC firm and the funded enterprise).
By analyzing the probabilities of success, venture capitalists are able to maximize earnings and attract new investors, as well as identify and select potentially attractive entrepreneurial ventures. They serve as intermediaries and, if their projections and analyses are accurate, they spur new growth, through new interest on the part of all concerned.
The ultimate goals of a good venture capital 'deal' -- all of which encourage the growth referred to briefly on Figure 1, above -- are to:
(1) promote stable financial conditions for the fledgling firm;
(2) foster policies which may lead to higher return on investment, i.e. profit, rewards and incentives for investors and entrepreneurs alike;
(3) ultimately obtain liquidity for the investor, as the enterprise matures and "goes public" through IPOs (initial public offerings); and
(4) cover losses with even more spectacular gains, when possible.
The foregoing goals represent an amalgam of opinions found in general readings on the subject of Venture Capital and apply to high-tech investments as well as to the classic VC investment model.
Because only one business venture, funded through a high-tech venture capitalist mechanism, out of ten succeeds, on average, the VC firm must nonetheless remain optimistic and ensure confidence in all aspects of its dealings. The eight or nine firms which wither and fail (known by venture capitalists, who even avoid assisting them, as 'numnuts', i.e. 'no money, no time') must be, if not hidden from sight, down-played in the shadow of the one or two successes enjoyed by the VC firm. In fact, this is the reason for portfolio diversification among such firms. While most entrepreneurs may never personally realize their dreams (their 'lottery mentality' did not bear fruit), the VC firm must remain solvent or it will not be able to attract future investment funds. These observations pertain to the high-tech sectors of today, as much as to the classic Doriot model of the 60s and 70s.
Growth patterns in this industry are crucial to examine. All sources of insight and information point inevitably to the states of California (Silicon Valley) and Massachusetts (Route 128) as the quintessential, ideal areas of maximal VC activity. Stanford University, Harvard and M.I.T. are all interrelated with the immense amounts of venture capital available for the ingenious schemes launched by their graduates. High-tech entrepreneurship is big business in these two locations, plus San Diego's bio-tech sector and parts of New York State and Connecticut.
The 1980s set the stage for the decade to follow. The typical venture-supported firm, during these years and thereafter, hired 153 people and exported some three and a third million dollars in merchandise or services, according to Professor Bygrave. (1997) These firms were large, but not old. They were about two years old, on average. VC-sponsored firms flourished, especially high-tech firms like GENENTECH, when older manufacturers (often Fortune 500 companies) were failing or stagnating. If we glance, in Figure 2 below, at just three M.I.T. brain-stormed firms which began operations in the 1980s, we see impressive employment and financial growth. All of these innovative high-tech companies were founded with venture capital. Similar ratings are available for Harvard-graduate inspired companies or institutions.
M.I.T. Inspired VC-Funded Ventures / Percentage of Growth Since Founding
Lotus 370.3 Lasartron 125.9 Thinking Machines 276.1
These companies, and hundreds of others, inspired the boom in venture-supported endeavors which spread, as early as the mid-1950s, from Route 128 in Massachusetts to Silicon Valley, just south of San Francisco. In 'Silicon Valley' (Menlo Park, Palo Alto, Los Altos, Mountain View, Sunnyvale, Santa Clara, and San Jose), more than 3000 high tech firms have been founded in the last 40 years. Not surprisingly, the dynamics which characterize these companies were (and are) similar to those on Route 128 in Waltham, Mass. During the initial growth cycle, largely funded by venture capitalists, Silicon firms were adding jobs at the astounding rate of 40,000 per year (Carlson and Lyman, Silicon Valley, quoted in Bygrave 1992). Since many of the venture backed firms had fewer than 100 employees, they were more flexible than the megalithic industrial firms of earlier decades. They grew, in fact, outstripping their larger cousins by creating and maintaining some 44 million jobs as of the decade's end in 1989. Large industrial Fortune 500 companies had grown during the same period at a far slower rate. (Forbes, Jan. 8, 1990) This would seem to imply that venture capital is more than mere money. Apparently, when "someone else's" money is at stake there is a strong incentive to perform honorably and efficiently. Large corporations such as IBM, Xerox or Burroughs cannot always inspire or sustain this thrust or drive which typifies a success-bound venture-supported company. The high tech sector has demonstrated this incentive-effect time and time again, early in the game with the "disk-drive industry", before the reduction from 40 competitors to only five in the 1990s, and later in this decade with successes such as socially conscious firms like bio-tech oriented Calypte Biomedical Corporation in California. (Silby, 1997)
Growth of individual firms multiplies into growth of the entire venture capital industry. Although there are fluctuations in the rate of expansion in this field, the trend seems to be toward further consolidation taking place in geographic locations previously successful, among others, in San Diego, Silicon Valley, and Hartford, for example. Beta Group in Menlo Park, next to Stanford University, is one of many VC firms in that town, most of which are housed in a single large building on Sand Hill Road. Beta's presence, along with other friendly, but competing VC firms, spurs growth in its specific niche concentrating on raising capital from individual investors many of whom are or were affiliated with five billion dollar Stanford University, under the fiscal management of Condoleeza Rice, Provost, who also serves on Chevron's Board of Directors. Indeed, within a 10 mile radius of Stanford, virtually everyone is connected with sources of capital of varying magnitude. Much of this funding is disbursed, via the interwoven and closely connected firms on Sand Hill Road, in the form of venture capital, targeting innovative high tech development schemes.
With such emphasis on computer-chip, semi-conductor and hard-drive development in the 1980s, bi-coastally situated for the most part, it is hardly surprising that growth in several other high-tech sectors seemed to occur in the 1990s. While this may be the case, there is sometimes not too much sense that can be made of the unpredictable nature and timing of growth in venture capital diffusion.
One of the factors leading to the irregular (but generally upswing) pattern of growth in the VC industry is that there is not necessarily a distinct correlation between the success of new stock issues (IPOs), for example, and the magnitude of VC funds disbursed in any sector of the high-tech industry. So, even though there was a slowing of the pace in public acceptance of new stocks, venture capital in the 90s continued to expand. Price Waterhouse was quoted as saying in November of 1997 that VC funding poured at unprecedented rates into high-tech companies, with a special focus on new software and communications. (Kawamoto 1997) Even in relatively narrowly defined sectors such as networking and infrastructural telecommunications equipment, sums of money raised by VC firms such as Juniper Network and Crosspoint Venture Partners literally swamped start-up and 'adolescent' stage firms whose ideas and concepts appealed to private investors, but also to well-known communications and computer corporations. In fact, established companies like Northern Telecom and Siemens/Newbridge paid such 'close attention' to new firms that, through VC companies, they and others contributed, as a single case in point, 40 million dollars (just to Juniper alone) for investing in budding new enterprises which could well become developing technologies that they themselves would be utilizing in the years ahead. (Kawamoto 1997) In fact, CNET News asserts, with respect to Juniper's success,
"This windfall brought the company's total financing to $56 million. Previous rounds of capital injection came from Kleiner, Perkins, Caulfield & Byers, New Enterprise Associates, Benchmark Capital, Crosspoint Venture Partners and Institutional Venture Partners." November 20, 1997
Some of this capital was shifted, obviously, from one capital venture firm to another, in this case to Juniper, but the entire package of liquid funding made available from a combination of sources to Juniper was impressive.
Thus, it can be readily seen that not only is VC growth typically spurred by private investors, but is also financially encouraged by major corporate interests that have something tangible to gain not only in the near or medium term, but possibly years down the road.
Sub-sector growth in the VC industry can be uneven or erratic over time. While there has been a software emphasis in the 1990s, military and communications-related applications and developments have also proven to be dynamic at intervals. Additionally, there are cycles, of course, which result in uneven development of the VC industry. Occasionally, massive amounts of funding are made available at times when no development is underway in the fields for which these funds were intended. This phenomenon is sometimes referred to in the literature as "dry powder", just waiting to be ignited if the correct combination of factors should materialize. When these cycles occur, they often rise to impressive heights before reduction in volume of capital available finally begins to establish new growth limits. Those individual investors, or established firms, who astutely synchronize and time their entry into the initial stages of an upward swing (and don't wait until the second or third round of VC investment in a given project or technology) can -- upon liquidation of their investment -- profit tremendously. For firms like Northern Telecom, investing through Juniper as we have seen, the benefits can prove to be multifaceted: capital enhancement, technological acquisitions and sometimes spin-off personnel transfers, resulting in their gaining new talent.
Growth of the VC industry, whether
(1) in the earlier high tech fields of chips, wafers and hard-drives which were, and still are, the turf of such dynamic venture capitalists as Hans Severiens and Mario Rosati (Sandoval 1998), or
(2) in the present day which is currently emphasizing communications, the Internet, software, laser technology and infrastructural equipment,
has clearly created new opportunities for industrial expansion and employment.
Indeed, the ever-broadening nature of venture capital availability in the American economy, and in prominent EEC nations where the concepts pioneered by Doriot and Flanders are truly catching on, has benefited the investor, the venture capitalist, bankers and an entire gamut of technical and engineering personnel.
This fundamental notion having been adequately established, it is important, initially, to turn our gaze toward the new directions this growth is currently taking, in more detail, and, secondarily, to assess the opinions of several knowledgeable analysts with respect to the impact these new directions in high tech venture capital investment may have on the economies of Western nations. Reference will also be made to managerial and industrial implications of new VC directions for the Pacific Rim and possibly for Third World nations in the decades immediately ahead.
III. New Directions in High Tech Venture Capital
In the last 15 years, not only has the entire VC industry grown, along with firms, like Beta Group in Menlo Park , which comprise it, but the intrinsic direction of the venture capital industry has also shifted to keep pace with demand, trends and innovative developments. Keeping in mind the the relative magnitude of VC funding in this country, which fills the specific niche of mid-maturity corporate support, particularly in the high tech field, it is enlightening to explore in what ways the emphasis in 'investments placed' has changed from the classic Doriot model, and how this may affect the immediate future and role of venture capital in North America and Europe.
Wayne Silby, in a reassuring article published in The Journal of Investing (Winter 1997), places his managerial, legal and economic background at Wharton and Georgetown in full view when he focuses on VC firms which invest in socially and ethically "correct" enterprises, many of which are high tech or bio-tech oriented. The main thrust of the company (Calvert Social Venture Partners) with which he is affiliated as a principal founder, is to combine the benefits of high profit with socially redeeming projects for future generations. His firm invests in about five new companies annually, with an average of $250,000 per firm, quite small by the standards of this industry. However, the efforts he has put forward have not gone unnoticed by other high tech venture capitalists who look on with a marked degree curiosity. Calvert's portfolio of entrepreneurial clients, fairly representative of the new direction that VC managers have been pursuing in the last decade and a half, is divided into
Health, Education, Energy and the Environment. There is an overlay, apparently, between high tech innovations and the energy sector about which we have not yet talked. Although the trend is definitely away from energy in the industry as a whole, Calvert found that a Princeton inspired 'solar-thermal water pump' was a well-engineered device worthy of a high-tech venture capital investment (with a socially redeeming aspect to it). Photovoltaics, the technology on which the pump was based, are still in vogue; in fact, as recently as two years ago, University of Texas (El Paso) Physics Department Graduate students were experimenting with similar technology. Calvert's client, World Water, is building a market in the developing world for these useful devices and hoped, as of 1997, to sell over one million dollars worth of product internationally. While energy, perhaps in the petro-chemical sense, has begun to lose its appeal, there are still related technologies which are eco-friendly and well supported by the investment community in the developed and developing world.
However, although Calvert invests in firms that are ecologically sound, this does not mean that extremely useful products must be avoided. On the contrary, the current trend, according to
Silby, reflects a need to re-establish priorities so that people benefit and socially desirable results are promoted. He states his purpose clearly in his cited article, justifiably entitled Social Venture Capital,
"When we are considering opportunities for the Calvert Special Equities Program, the social impact of the venture comes first. How does the company's product or service address an unmet social or environmental need? What will be the impact of the company's product or service on future generations?" (Silby 1997)
One category of venture capital investment which lends itself quite well to this new direction in thinking is the bio-medical field where developments are progressing by leaps and bounds. San Diego harbors the nation's largest cluster of progressive and dynamic bio-tech firms, with others located in Silicon Valley, Georgia, Florida and Massachusetts. Once again, because of his firm's conviction that eco-biologically sound products must be supported, Silby has invested in two companies which meet his criteria. Earth's Best is a babyfood producer which relies solely on organic ingredients in its products, thus reassuring mothers that neurological problems related to insecticides and artificial ingredients will not develop, now or in the future, in their babies. It relies on high-tech developments to ensure purity and quality standards for its products. This concept was so attractive that H.J. Heinz invested heavily in the Earth's Best company by purchasing a half a million dollars in stock. Silby's firm initially invested in Earth's Best at half the ultimate cost per share, thus realizing a handsome profit, on the order of a quarter of a million dollars, when the Heinz offer was finalized. Earth's Best founders and staff also profited since they had invested in their own company, although on a somewhat smaller scale.
These examples (a solar water pump and organic babyfood, among others) point to recent modification of prior thinking in the field of venture capital on both a micro- and macrocosmic scale.
More conventional high-tech firms are also benefiting from a re-direction of such thinking. In the first nine months of 1997, for example, certain high-tech firms attracted more venture capital for their innovations than in all of 1996. This represents phenomenal growth (over 25% annually), but also reveals trends which began to occur in the last few years of the 90s. There are dynamic cycles which occur in the VC industry and, as perceptions change, so do investment strategies and directions.
In Tokyo, Trend Micro is developing anti-virus software which represents a new direction in the computer industry. (Itoi, 1998) Whereas the last three decades were devoted to perfecting the actual computers and basic software for them, the next decade may well move toward development of protection systems in view of the increasing vulnerability of industrial and government files and accounts. There is an increasing demand for these and other Japanese-engineered products. In June of this year, for example, the FBI began prosecuting individuals found to be defacing government web-sites which are apparently still quite vulnerable. Trend Micro's products, and products similar to them, are becoming increasingly popular among security-conscious computer users, whether in business, government or in private homes.
Whether new VC investment directions internationally seem to be pointing to refinements of the computer sector, and nationally toward ecologically acceptable technologies, on the homefront in New Mexico there is also some indication of new thinking which will give rise to a flow of venture capital in the high-tech sectors and industries mentioned in Los Alamos National Laboratory press releases. In fact, the Lab sponsors periodic seminars and conferences, such as the one held on June 25, 1998 during which workshop participants discussed technical and financial strategies and insights developed over the preceding year. (Sandoval 1998)
During this series of workshops case studies were presented and specific details related to how venture capital can be secured were shared with participants. Some of the case studies dealt with topical issues and new approaches, not only to finance, but to the technologies requiring capital investment. For example, there have been developments in the area of aerosol improvement, particularly in light of on-going ozone depletion. Venture capitalists focused on the possibility of improving existing products with plans to support research and then, because VC firms are interested in profit, marketing of the improved environmentally safe version of existing aerosols. (http://libwww.lanl.gov/ejournals/PHYS.htm) Data pertaining to venture capital initiatives being sponsored by Los Alamos National Lab are available from the Technology Commercialization Office, a branch which deals, by interfacing, with all aspects of facilitating development of high-tech innovations within the public and private sectors.
What seems to be of special interest in the instance of local VC activity is that it involves government, defense and high-tech. This could well prove to be a new emphasis as well in the VC industry. Where development is occurring, and new products being perfected, the need to market them -- whether to agencies or to the general population -- inevitably arises at some stage of the process. When economic activity expands, there seems to be a corresponding surge in VC firm involvement. In the case of New Mexico which, by national standards, has an extremely limited industrial and economic infrastructure, the innovative process may touch many segments of society: defense, agriculture, service industries, or high-tech. The stage is set here, as well, by such major players as Los Alamos, to foster development and encourage further growth of the VC industry, interconnected with a regional network of credit unions and smaller banking institutions.
Summarizing new directions for the VC industry, it can be said that bio-technology is surely an area being scrutinized, as are environmentally friendly sectors. Overseas, state-of-the-art products in the computer industry are being financed by VC firms, and nationally government, scientific agencies and think-tanks are pooling their intellectual talents to generate new and improved products, all of which will - at the intermediate stages of dissemination -- be supported by venture capital in one form or another. It can be said that diversification of VC emphasis seems, therefore, to be the new directional trend on the threshold of the new millennium.
IV. The Crucial Role of Venture Capital Firms in the High Tech Sector
In previous remarks, the role of venture capital was alluded to within the context of the industry's growth, but was not defined or situated within the economic community with any great degree of precision. The lay observer is convinced that the American system relies heavily on venture capital firms to feed the economy, and yet this is a misconception. VC firms play a very specific role, and quite a narrow one at that, in the chain of industrial development across a broad spectrum of undertakings. The niche enjoyed by venture capital in the high tech sector is, of course, even narrower. This level of specificity does not mean, however, that VC firms are unimportant; indeed, it will be seen that the opposite is, in fact, true.
In 1997 only 10 billion dollars was invested in venture capital, and somewhat less than that sum was allocated to the high-tech sector. Putting this figure into perspective, it can be seen that a mere fraction of the war in Kosovo could be financed with this sum, or that the U.S. Government spends 63 billion to develop technical and non-technical projects, and that the corporate sector disburses some 133 billion to fund on-going projects which may or may not culminate in useable technology. (Zider 1998)
Other sources (notably Burrill and Norback 1988) confirm that, in the 1980s for instance, non technological VC investments totaled about 3.6 billion dollars for six years, of the sixty billion presumably invested in those years, using the 90s rate of 10 billion annually, in the United States. Simple calculation, based on the assumptions mentioned, would indicate that the remaining 56.4 billion might have been invested in the high-tech sector for those years.
The 10 billion available for venture capital funding is ear-marked, by private VC firms, for special use at critical stages of a promising entrepreneur's company. Furthermore, the money made available to the qualified entrepreneur is not long-term funding; it is managed by the venture capitalist and brought to maturity for liquidation, or cashing-in , at the appropriate time, usually when the sponsored firm is ready to issue its first stocks to the public. This phase of profit-harvesting is also known discretely as "exiting." (Burrill and Norback 1988) In effect, exiting represents the culminating act of the venture capital stage of development, and is a legitimate end in itself. The harvesting of profit is as American as apple pie; whether the fledgling firm is protected thereafter from financial disaster is placed in the hands of the new firm's own management team as they move toward the public equity markets, stock issues and the larger world of corporate paper, derivatives, brokerage houses and other speculative vehicles.
It can be inferred from the foregoing that VC funds, therefore, are not start-up capital, not seed-money, not R&D financing, and not long-term investments for any party involved in this process. The venture capitalist's role is to provide a bridge between the entrepreneur's 'angel' financing (friends, extended family or private savings) and the phase when the business venture can begin to contemplate going public. The venture capitalist takes a considerable risk, actually, since just as angel financing runs out, the VC firm steps in, as an intermediary, to support a concept, idea or innovation which may or may not be marketable. There must be a valid reason for the capitalist to adopt such a risk, one which he deems acceptable. Although these investments do not generally last beyond 5 years, the average profit expected by the investors and the VC company ranges approximately from 25 to 35% per year on the initial sum put forward. (Bygrave 1992, Zider 1998) Risk assessment is a major part of this equation. Once mastered, however, the knack of selecting profitable firms stands to result in a viable, sound reputation for the VC firm with a record of relative success. In his effort to attain a good reputation for sound decision-making in the investment community, the VC manager, and, in fact, his entire firm, must rely on proper strategies to identify trends in the high-tech industry and to identify reversals, slow-downs or probable directions. Brendan Moynihan's text entitled Trading on Expectations (1997) alludes to human behavior, uncertainties and the history of booms and busts in various economic sectors. The insights described in his analysis can be indispensable to the VC manager in deciding which firms to support, and, hence, in determining the 'reputation' which will inevitably 'stick with him' in his locality.
Revealingly, there is a discernable sequence or chain of events into which the VC firm steps, thus filling a void and serving a distinct, vital purpose. On Figure 3, below, the six players in this scenario, whether in the high-tech sector or not, are displayed as they generally interact, each benefiting if all goes well.
Innovators & Venture Capital Bankers & Investment Firms
Entrepreneurs Firms State & Federal Governments Individual Commercial Markets & and Private Corporations Investors Large Firms
(chart not coded for proper on-line display)
There is an exchange of assets in each of the above relationships. The innovator provides ideas to the venture capitalist, who provides him with funding. Corporations and Government Agencies may have provided the innovator with R&D support, in exchange for which the innovator may well agree to collaborate with the agency at a later stage. Venture Capitalists interact with individual investors who provide funding and ultimately profit, in a two-way exchange. Bankers, on the other hand, are involved in the launching of Initial Public Offers (IPOs) and provide intermediary services between the VC firm and the commercial markets in large urban centers. The above figure also demonstrates a number of other relationships involving the transfer of expertise or funding. Judgment and integrity are important factors in the roles of each of these players and certain regulations apply, even though the VC industry seems less regulated than more formal financial institutions. Occasionally, these entities enter into partnerships or pools where funds are amassed and risks somewhat minimized. If the total amount of capital involved rises into the hundreds of millions of dollars, VC managers can earn handsome salaries (hundreds of thousands annually) representing between 1 and 3% of the total at stake, over a period of some 5 to 7 years, according to Zider, Bygrave, and others who generally concur.
Before a venture capitalist will even consider investing in a new firm (one running short of start-up capital) he will invariably expect the entrepreneur to display what is known in the industry as "due diligence". (Burrill, Norback 1988) This involves a proper presentation (or prospectus) to the potential capitalist, often an on-site tour of the business and a formal meeting of the aspiring firm's management team. Frequently , there will be a research component to the due diligence requirement, entailing an in-depth analysis of the market for the product or service being provided. In the case of high-tech, even minor new developments, if researched properly, are often supported due to their potential for lucrative proceeds at some stage of marketing and wide public acceptance. For example, Dr. Vladimir Shalov's new laser discoveries within NMSU's Physics Department (The Round-Up 1999) may prove worthy of attracting a serious offer from venture capitalists due to their apparent potential for increasing computer processor speeds several hundred-fold. The role of the VC firm, in this instance, would be to finance post-pilot studies of the newly developed technology with an eye toward commercial or military applications.
The primary role of the VC firm could be construed as advisory. It must be remembered that such firms are dealing with dozens of accounts at a time, and actual hands-on expertise might be difficult to implement on such a broad based scale. So, phone calls, video-conferencing and occasional meetings with the entrepreneur are all that can be realistically expected. The balance-sheets are what attract the most scrutiny, not how 'micro-circuits' are being assembled.
In rare instances, the entrepreneurial firm may have a full staff of technical personnel, but may be lacking a CEO type figure. The VC specialist may fulfill this role temporarily, as he or she helps the firm seek a permanent solution to this administrative shortcoming. This temporary fix also allows the VC firm to assess the inner-workings of the firm and make suggestions resulting in enhanced internal efficiency.
In a segment on assessing the role of the VC specialist, it would be negligent not to mention that such a specialist must also be prepared to grasp the theoretical notions of investment dynamics. In 1953, for example, a monetary theorist named Kenneth Arrow defined what he called the general equilibrium model for capital markets. It was connected with the idea of both discrete and continuous time models of investment. There are optimum times for investment and less desirable periods. The Arrow theory and others (notably those of Black-Scholes and Modigliani-Miller) can assist the VC specialist in assessing prices and values for assets and products within a given time frame. (Duffie 1992) Mastery of these complex economic paradigms is not always necessary for a good VC firm, but having at least one investment consultant conversant with them on the staff is quite helpful.
Somewhat simpler reference works can be useful for the VC consultant who spends a fair percentage of his time advising client-firms. Even if a grasp of the intricacies of investment theory is not possible for many VC managers, they have, nonetheless, ready access to constantly updated source materials and fluctuating indicators on the Internet. Additionally, they can rely on the vast array of explanatory text books available in the field of investment and venture capital, among them
Karen Chapman's Investment Statistics Locator which includes more than 22 standard sources for obtaining the vital information so necessary for making informed decisions in dynamic markets.
Another source of evaluating reliable firms which may be sources of capital for the VC manager is the well known and widely respected Standard & Poor's Register of Corporations, Directors and Executives. This volume, and accompanying supplements are updated periodically to reflect new arrivals to the business scene or the results of mergers, buy-outs or executive shake-ups.
For investigating the company histories of potential donors of funds, or for evaluating companies where entrepreneurs may have worked in the past, the VC manager can obtain inside information from Thomas Derdak's International Directory of Company Histories which features more than 250 companies in each volume of an impressive set of large format books. The background information on high-tech firms in the Derdak compilation is also useful in assessing new trends or emerging technologies possibly worthy of funding by a VC firm. There are also a number of periodicals which inform the VC specialist of information critical to making proper decisions under often difficult circumstances. His challenge is to be consistent in earning a high return on investment (ROI) for his investors, and his own firm, in a climate of uncertainty due to the unproven nature of his entrepreneur's undertaking. How may Apple Computer type firms, begun in the garages of America, might have failed before the one success we are all aware of materialized? There were doubtless thousands of failures, some of which were funded by "angels" to begin, and by VC firms in mid-maturity. Failures in the disk-drive industry, in its early stages, are monuments to the risks inherent in the high-tech business. Balancing risk versus potential profit is a delicate task.
In fact, risk assessment is a vital part of learning to manage venture capital investments, both prior to the entrepreneur-selection decision and thereafter. A sample risk-assessment formula, in this instance an elementary model assessing the risks inherent in the transport of diamonds, is provided in Appendix A (to be hyperlinked in the near future) for brief review; however, considerably more complex models exist which include a much broader range of criteria and far more sophisticated mathematical permutations. This methodology is an integral part of a VC manager's daily functions.
Returning briefly to the concrete aspects of VC operations, it can be said that the VC manager spends much of his time daily (25%) serving as either a 'director-administrator' or as a monitor of the protected companies over which his firm has control. Secondly, he spends time recruiting qualified management (20%) for his 'protected' firms, and, thirdly, he acts as consultant (15%) regarding internal problems among his firm's entrepreneurial protégés. These figures, reflecting percent of man-hours spent daily on the tasks mentioned, are derived from Zider's insightful Harvard Business Review article (1998). Surprisingly, Zider seems to minimize the importance a VC manager may assign to assessing risk. Looking at how well qualified the prospective firm's personnel are, looking at the actual product or service to be produced analytically, reviewing the firm's growth and expansion plans and seeing what philosophies guide the firm's founders are all important criteria which need to be judged and weighed by the VC firm prior to a final decision to support it financially through it's 'adolescence.'
Although a quarter of the VC specialist's time is ostensibly spent on literal management of the protected firm, a major secondary task (a corollary to the first) is to recruit capable leadership for the new enterprise. The innovator-engineer who first approached the VC firm may, at this stage, begin to feel as if control of his business is being wrenched from him; nonetheless, he must sooner or later recognize that expert administrative support is essential to proper growth and sustainability of the new firm.
The VC firm's job is, in addition to other functions mentioned, to secure adequate managerial personnel to steer the new company toward viability in a tough and highly competitive high-tech market. He must determine the search criteria by gathering and evaluating information on the backgrounds of qualified candidates. He is, among other criteria, seeking the qualities of consistency of performance and indications of a cogent management style in the candidate. (Davenport 1990)
It has been postulated that a former equity manager might be an ideal candidate for the blossoming high-tech enterprise when under the guardianship of a VC firm. So, the criteria for selecting a good equity manager might well be used by the VC manager in his quest for a viable candidate. If a 20 million dollar investment is being made in the new firm (a not atypical amount), then the search must be understandably professional, predicated on the selection characteristics outlined in such texts as Davenport's (1992). Primary among the qualities sought, it is important to reiterate, is consistency of performance in the candidate's professional history. All of the basic rules of the decision-making process should be observed during the recruitment process.
Since this selection process is an integral part of his role, we could legitimately inquire: What, exactly, is the VC manager looking for in a potential entrepreneur? The qualities, objectives and priorities listed below on Figure 4, slightly adapted on the basis of several articles, foremost among which is Zider's Harvard Business Review article, seem to reflect the particular mix which is most appealing to the VC firm in its quest for a viable candidate. These criteria appear quite 'stiff', and, in fact, a better idea of this highly competitive realm can be obtained from reviewing them:
TEN CRITERIA SOUGHT BY VC MANAGERS WHEN EVALUATING ENTREPRENEURS
1. The area of technical expertise being offered must be in high demand 2. There must be reasonable certainty that licenses & permits from government can be obtained 3. The entrepreneur must be eloquent, articulate and presentable 4. He must accept the notion of ultimately "going public" through IPOs. 5. His reputation must be well established, and based on competence in his technical field 6. He must be a team-player, able to accept that many talents are needed to succeed 7. As Doriot said: "He must be an A man with a B idea, not vice-versa..." 8. He must be personable, able to get along with investors, and flexible. 9. He and his idea must be 'in demand' in the VC community 10.He must be a realist, as opposed to an idealist or a pure theorist.
As has been readily demonstrated, the role of the VC firm and its managerial staff, particularly in the high tech industry is extremely crucial since, if it is executed properly, it ensures the viability of the firm being nurtured which would otherwise fail outright, or 'droop' at critical points of its development. Identifying the right combination of factors is the principal job of the venture capitalist who, with his staff, reviews all criteria likely to affect their firm's decisions.
V. Venture Capital Beyond 2000: Globalization of High-Tech Industries
In preceding segments dealing with growth, direction and role of venture capital in the high tech sector, this analysis has identified many of the trends which seem to be dominating the VC industry and has clarified the parameters, purposes and impact of this dynamic economic strategy launched by Doriot and Flanders in mid-century. The attractiveness of venture capital surpasses, in the eyes of many investors, the benefits of bank investment vehicles, stocks, bonds, corporate paper, and even (or perhaps especially) derivatives. While there is a failure rate among VC-financed enterprises which has been discussed, the 'lottery mentality' of most American entrepreneurs, and of their counterparts in Europe and Asia, tends to dominate this industry. All parties in the entrepreneurial chain seem to benefit if conditions are propitious and events coalesce as foreseen. But the gnawing question is not so much focused on the dynamics of venture capital, well-understood, but rather on the future of the industry. Where, in effect, will this seeming spiral of growth lead in the new millennium?
Leaping before the eyes of investors and venture specialists, who foresee this as a trend of the future, are indications of 'global' developments as close to home as Canada where the Bank of Montreal (BOM) and Capital Alliance Ventures (CAV) have, just last year, concluded a 1.25 million dollar arrangement which may seem small by US standards, but which indicates ever-expanding interest in new financial configurations, based on the classic Doriot VC model, in the area of high-technology. In this case, the recipient of Capital Alliance's VC funding was International Datacasting (IDC), a satellite broadcasting firm. Within the context of this new financing agreement, IDC's Chief Executive Officer, Ron Clifton, was quoted as saying,
"This investment is timely and significant for us. Not only does it provide additional financing for working capital as we expand into the high-speed data broadcast arena, but also brings a new strategic partner into the Corporation. The BOM brings additional strength to our Board, as well as broad international connections. The additional investment by CAV is a welcome vote of confidence for us. Combined with our expansion into new product lines and new markets, this new investment will be a big step forward for us."
-- Canada News Wire, July 7, 1998.
Broadly defined socio-economic trends, of which the venture capital movement is definitely a critical part, often begin in a circumscribed area, such as Montreal, Waltham, or San Jose, and expand regionally, nationally and worldwide if conditions favor their proliferation. While the computer industry is reaching its peak in the advanced nations, on-going development of technical improvements and high-precision enhancements seems to be sustaining high levels of activity even in these electronically dependent and sophisticated locations. (Itoi, 1998) This is a reassuring indication of the likelihood that, along with the ubiquitous Internet, cybernetic equipment, electronically-based telecommunications systems, and a bevy of other high-tech applications the VC industry will follow, hand-in-glove, these expanding trends. In fact, parallel stages of dual development (VC and technical) are expected to occur in Western nations, and perhaps in many Asian locations, throughout the opening years of the new millennium. As high tech spreads its wings, so, too, will the VC industry keep pace. In fact, it can be validly suggested that venture capital may well precede this high-tech relocation to new locations abroad, and will tangibly assist in the creation of new industry. Where markets are developing, availability of capital and growth are inevitable. Talk of Latin America, Asia and perhaps Africa is beginning to filter into conversations in Menlo Park and Waltham, according to several articles notably in the Red Herring Release of November 1998 (Itoi) and in the business press.
Surely, Tokyo, Hong Kong, Singapore and Seoul are able to serve as stepping stones to VC markets in the interior of Asia where the PRC, in light of economic reforms approved by Beijing, is increasingly receptive.
Similarly, Buenos Aires, Caracas and Mexico City, within the context of new multi-lateral accords such as NAFTA or on the basis of existing commercial ties, should be able to serve as platforms for VC development in Latin America. However, less optimism exists in strife-torn or hurricane-damaged countries like Nicaragua or El Salvador. Instead of rebuilding, United Fruit may abandon its Central American banana plantations, representing one major indication that conditions are not yet ideal in this sector of the world for further development of VC firms.
Turning briefly to the continent of Africa, it is acknowledged that Durban, Capetown, Port Elizabeth and Johannesburg are already enjoying the presence of capital markets, venture capital firms and economic sophistication. Looking beyond present economic conditions, observers note that the peaceful presidential elections of Summer (Winter) 1999 should further solidify confidence in the Republic of South Africa's transitional period from the rule of apartheid. Just to the north of South Africa, in Botswana, it is known that the Gaborone Stock Exchange, according to an informal statement by a Botswanan graduate agriculture student at New Mexico State University, features 11 stocks on its 'big board', and, with only one million people, it would still seem as if financial markets, and the venture capital sector in particular, might have a moderate chance of expansion and development. On-going talks with the former colonial power, the U.K., are known to take place in this sense, and American corporate executives are looking into coal development schemes in Botswana, which might rely , in full or in part, on venture capital. Lastly, with respect to Africa, the M'bendi Information Service, suggests periodically that governments in Zambia, Zimbabwe and Kenya are providing seed-capital for R&D, start-up and temporary support of parastatal high-tech industries, particularly in the area of telecommunications.
The VC industry is competitive. European firms will not idly stand by and allow American capital to reap profits in lucrative markets. Therefore, it can be anticipated that a certain level of friendly and not so friendly interaction will take place among venture capitalists in Asia and Africa.
Indeed, U.S. venture capitalists, even those of Menlo Park and Waltham, are not poised to monopolize new high-tech development potential in overseas markets. The new millennium will assuredly determine which forces will prevail. Germany, Japan and the U.K. have already been found to be assertive players, as has the U.S., in a profitable, risky and dynamic game with high, and high-tech, stakes.
For purposes of analysis, as has been seen, high-tech venture capital can be divided into three principal theaters of operation, namely bio-medical technology, military technology and computer-related developments. With a view to all three sectors, the growth of this industry has been profiled and observations offered. The high tech field is expanding exponentially since not only is globalization of VC firms occurring, but expansion in a number of technological sectors is creating accelerated demand for capital. The somewhat narrow niche which VC plays in the overall scheme of development is a critical link in the chain of events leading to sustainability of new firms. The initial ideas and concepts pioneered by Harvard's Professor Doriot, as interpreted by a generation of successors also at Harvard and M.I.T., have led to establishment of an entire industry which is now responsible for ensuring the 'adolescent stage' growth and viability of important new companies improving the quality of life for the world's citizens.
The direction which the VC industry has taken in the 1990s has also been reviewed and profiled. The abandonment of energy in favor of an emphasis in the high-tech sector is probably the most prominent phenomenon of this period. With a reasonable success ratio when sponsoring high-tech firms, VC specialists are convinced that the highest profits and the lowest risks lie in this field. The open question looming at them moment on the threshold of the new millennium is where will the VC industry now turn? There are new sub-specialities (bio-med, for example) into which these billions of dollars may be poured, according to some sources; and, yet, there is also a body of opinion which feels that high-tech as it has been developed thus far (Internet, PC industry and military applications) will continue to dominate the VC market orientation. The contribution of governmental and institutional research will also determine the directions in which VC may be headed in the decades to come.
The role of the VC firm and its staff, within the entire economic sphere of activity, was fairly thoroughly elucidated. Interaction with investors, bankers, government, the equity markets and technical or entrepreneurial innovators forms the backbone of daily involvement. However, in addition to the often tense involvement with other players, VC managers are also responsible for mastery of investment theory and for serving as advisor for their client-entrepreneurs. Evaluation of potentially successful ideas, fledgling firms and high-tech innovations, as they emerge from their angel-financing phase, also occupies a good portion of the VC director's time.
When all is said and done, the energetic and dynamic forces which are currently propelling high-tech development will inevitably continue to interact with venture capitalists and their companies, but will do so on an increasingly global scale. Sums made available for start-up companies may be increased in some high-demand sectors, but the main thrust of VC funding will still concentrate on sustaining through mid-growth development those firms which have shown promise in their initial stages.
Yet, in the last analysis, and after reading extensively in the literature cited, it was somewhat surprising to note that, although venture capital would seem to form the crux of the American Economic System there is relatively little of it available in sectors other than high-tech. Even in the high-tech field venture capital is hard to obtain and arduous negotiations and protocols are a necessary part of the risk assessment process.
From a purely 'industrial management' standpoint, the availability of start-up funding, followed by sufficient venture capital, and ultimate acceptance on the equity and public capital markets (in this country the NYSE, AMEX, NASDAQ) comprise the standard route taken by high-tech firms which have an idea, pursue it, and remain tenaciously committed to their goals and objectives. Learning to make sure that the VC link in this "chain of entrepreneurial survivability" is strong and effective is the job, not only of the VC manager-director, but also of all properly trained industrial managers.
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