Have We Oversold the Role of Venture Capital?
Jonathan Ortmans, President, Public Forum Institute
There has been a lot written in the past few days on how to revive the Venture Capital (VC) industry in the U.S. However, we need to keep the bigger picture in mind and avoid making the mistake of equating new firm creation, job creation and economic recovery to the health of the VC industry. VC investments are only one component of the capital market for new firms. Policymakers’ efforts should focus on the larger entrepreneurial ecosystem, rather than just on the VC industry.
Don’t get me wrong; venture capital has certainly made some significant contributions to our innovative economy. A NVCA study highlights that the nation’s VC-backed companies jointly employed over 10.4 million American workers and generated $2.3 trillion in revenue in 2006. The total revenue of VC- financed companies comprised 17.6 percent of the nation’s GDP and 9.1 percent of U.S. private sector employment in 2006. There are also good reasons behind the NVCA’s poverty plea. According to the MoneyTree™ Report, VC investment dropped 61% dropped in first quarter of this year from the same time last year. Moreover, there are a few notable successful VC firms which build companies for the long-term, build companies’ management teams and help to finance growth.
But since entrepreneurship is what we need to ignite in this economy, it is important to acknowledge that the vast majority of startups are “bootstrapped” by entrepreneurs who borrow from banks and credit cards to get started (see Kauffman’s longitudinal survey of new firm creation). Additionally, data shows that over 22 years, venture funds invested in only 36% of companies successful enough to list in public markets. Harvard’s Josh Lerner further suggests that the number of exceptional venture capitalists is very, very small. Also, Kauffman’s Paul Kedrosky analyzed the Inc. 500 list of the country’s fastest growing companies. Of 800 companies on the list during the past 10 years, 645 were either angel-backed or bootstrapped. Only 155 firms used venture funding.
Recently, the National Venture Capital Association (NVCA) has released its recommendations to restore liquidity in the VC industry. The NVCA’s recommendations rest on four pillars: ecosystem partners, enhanced liquidity paths, tax incentives, and regulatory review. The association advances that “(t)his capital markets issue is not just a venture capital industry problem; it is a U.S. economic concern,” suggesting that “we can expect job growth to disappear over time.”
As presented though, these recommendations will likely not unleash start-ups and job creation. This is primarily because the NVCA diagnosis of the problem in the capital markets narrowly focuses on the VC ecosystem. Harold Bradley, Chief Investment Officer at the Kauffman Foundation, pointed out that the VC ecosystem is only one component of America’s entrepreneurial ecosystem. With his permission, I will discuss here some of his insights because they help disabuse us of “urban myths” about the role of the VC industry in our entrepreneurial economy.
The NVCA’s first pillar calls for the return of small investment banks and accounting firms so that these can partner with their bigger counterparts. Harold reminds us that such VC ecosystem supported corrupt practices in the past. It allowed VC firms to control the pricing and allocation of new companies sold to the public through boutique investment banks. The “hot IPOs” went to people friendly to the firm, and to prospective companies that the VCs identified as prospects. Hot stocks were allocated in the afternoon on the day of the IPO at the “issuing price.” On the next day, they sold into public demanding up to 15%, 20% and more. It was an insider’s game and the investing public paid the costs. For a clear historical view of the economics of the VC business, I encourage you to read this account. There, Harold tells taxpayers what the VC dynamics have been in the past and recently from an outsider’s perspective.
The second pillar, enhanced liquidity paths, calls for new forms of exits, such as exchanges where start-ups can sell shares on the private market. This addresses the falling number and slower rate of IPOs (Initial Public Offerings) and M&A transactions in recent times. There NVCA points out that there were only 6 IPO’s and 341 M&A transactions in 2008, and that it now takes on average 9.6 years to get VC-backed companies public or 6.5 years for an M&A transaction.
However, according to IPO data collected by Jay Ritter at the University of Florida, the median number of new companies listed in the market since 1987 (the last market crash) was just 227. Only one in three of those companies required venture finance to go public. In only two years, 1999 and 2000, did more VC-backed companies list in the public markets than non-VC backed companies.
The NVCA calls for a new intermediary, privately-owned system that reconnects sellers and buyers of venture-backed company new issues. The report claims this will be an “enhanced distribution system.” As Harold rightly questions, enhanced for whom? Perhaps a better, more democratic solution lies in the concept of Open IPO, which has already been used by Boone Pickens, Google and other companies. Open IPO removes any ability for the venture insiders and Wall Street’s brokers to either control price or dictate allocation. This system allows for buyers to place anonymous orders within a system and to be rewarded with shares for paying a higher price. It prevents IPOs from getting hot because artificially low prices cannot happen.
The third pillar seeks tax benefits, such as a more competitive capital gains tax rate for IPOs and capital gains taxes only on partnership revenues. Again, it is doubtful whether tax relief targeted at the VC industry will spur new business formation. As mentioned above, most new companies in the U.S. do not rely on VC funds, suggesting that tax relief for startups might create greater entrepreneurial returns.
Finally, the last pillar refers to a systemic problem affecting the sector, regulation. The NVCA wants less burdensome regulations (e.g., Sarbanes-Oxley and financial statement requirements) for smaller companies trying to reach an IPO. In this regard, it is important to point out that public offerings have historically been a very small fraction of the VC industry’s liquidity. Most venture companies were sold to bigger public companies in merger transactions (e.g., Cisco’s acquisition of Linksys).
I am grateful and applaud NVCA for driving a dialogue in ensuring the nation focuses on the often unsung array of high growth startup “job creators”. However, while a healthy economy needs a vibrant VC industry, the government should be cautious before taking on such a big but narrow rescue plan without examining carefully the entire funding ecosystem that sustains entrepreneurship and drives new job creation in the private sector.