23 Nov 1999  Research & Ideas

The Future of the Venture Capital Cycle

Despite many success stories and a rapid rise to prominence, the venture capital industry remains a mystery to most, and questions about its sustainability persist. In this excerpt from their pathbreaking book The Venture Capital Cycle, HBS Professors Paul Gompers and Josh Lerner look toward the future of this misunderstood financial intermediary.

 

Over the past two decades, there has been a tremendous boom in the venture capital industry. The pool of U.S. venture capital funds has grown from less than $1 billion in 1976 (Charles River Associates 1976) to over $60 billion in 1999. This growth has outstripped that of almost every class of financial product.

The supply of venture capital is also likely to continue growing. Within the past two years, numerous pension funds have invested in private equity for the first time. Many experienced investors have also decided to increase their allocations to venture capital and buyout funds. These increased allocations will take a number of years to implement.

Book Cover: The Venture Capital Cycle

This growth naturally begs the question of sustainability. As has been highlighted throughout this volume, short-run shifts in the supply of or demand for venture capital investments have had dramatic effects. For instance, periods with a rapid increase in capital commitments have led to less restrictive partnership agreements, large investments in portfolio firms, and higher valuations for those investments. These patterns have led many practitioners to conclude that the industry is inherently cyclical. In short, this view implies that the side effects associated with periods of rapid growth generate sufficient difficulties that periods of retrenchment are sure to follow.

Neoclassical economics teaches us to examine not just the short-run supply and demand effects. Rather, it is also important to consider the nature of long-run supply and demand conditions. In the short run, intense competition between private-equity groups may lead to a willingness to pay a premium for certain types of firms (e.g., firms specializing in tools and content for the Internet). This is unlikely to be a sustainable strategy in the long run: firms that persist in such a strategy will eventually achieve low returns and be unable to raise follow-on funds.

The types of factors that will determine the long-run, steady-state supply of venture capital in the economy are likely to be more fundamental. These most likely will include the magnitude of fundamental technological innovation in the economy, the presence of liquid and competitive markets for venture capitalists to sell their investments (whether markets for stock offerings or acquisitions), and the willingness of highly skilled managers and engineers to work in entrepreneurial environments. (The last factor in turn will be a function of tax policy, legal protections, and societal preferences.) However painful the short-run adjustments, these more fundamental factors are likely to be critical in establishing the long-run level.

When one examines these more fundamental factors, there appears to have been quite substantial changes for the better over the past several decades. [NOTE] We will briefly discuss two of these determinants of the long-run supply of venture capital in the United States, where these changes have been particularly dramatic: the extent of technological innovations and the development of regional agglomerations.

While the increase in innovative outputs can be seen through several measures, probably the clearest indication is in the extent of patenting. Patent applications by U.S. inventors, after hovering between forty and eighty thousand annually over the first eighty-five years of this century, have surged over the past decade to over 120 thousand per year. This does not appear to reflect the impact of changes in domestic patent policy, shifts in the success rate of applications, or a variety of alternative explanations. Rather, it appears to reflect a fundamental shift in the innovative fecundity in the domestic economy. The breadth of technology appears wider today than it ever has been before. The greater rate of intellectual innovation provides fertile ground for future venture capital investments.

A second change has been in the development of what economists term "agglomeration economies" in the regions with the greatest venture capital activity. The efficiency of the venture capital process itself has been greatly augmented by the emergence of other intermediaries familiar with the workings of the venture process. The presence of such expertise on the part of lawyers, accountants, and real estate brokers, among others, has substantially lowered the transaction costs associated with forming and financing new firms. The increasing number of professionals and managers familiar with and accustomed to the employment arrangements offered by venture-backed firms (such as heavy reliance on stock options) has also been a major shift. The market for new issues by venture-backed firms appears to have become steadily more efficient, as part III of this volume makes clear. In short, the increasing familiarity with the venture capital process has itself made the long-term prospects for venture investment more attractive than they have ever been before, in this country or abroad.

A corollary to this argument is perhaps even more important. These changes appear not to have been entirely independent of the growth of venture capital, but have been at least partially triggered by the role played by these financial intermediaries. For instance, much of the growth in patenting appears to have been spurred by the growth in the number of venture capital-backed firms (Kortum and Lerner 1998). In short, it appears as if there is somewhat of a "virtuous circle," where the growth in the activity of U.S. venture capital industry has enhanced the conditions that drive the long-run value creation of this capital, which has in turn led to more capital formation.

As the various chapters of this volume have highlighted, much is still not yet known about the venture capital industry. The extent to which the U.S. venture model will spread overseas and the degree to which the American model will — or can — be successfully adapted during this process are particularly interesting questions. Clearly, this financial intermediary will be an enduring feature on the global economic landscape in the years to come.

It is also worth emphasizing that despite its growth, the private-equity pool today remains relatively small. For every $1.00 of venture capital in the portfolio of U.S. institutional investors, there are about $100 of publicly traded equities. The ratios are even more uneven for overseas institutions. At the same time, the size of the foreign private equity pool remains far below that of the United States. This suggests considerable possibilities for future growth. The disparity can be illustrated by comparing the ratio of the venture capital pool to the size of the economy. In 1995, this ratio was 8.7 times higher in the United States than in Asia, and 8.0 times higher in the United States than in continental Europe. (These statistics are taken from the European Venture Capital Association 1997 and Asian Venture Capital Journal 1996.) At least to the casual observer, these ratios seem modest when compared to the economic role of new firms, products, and processes in the developed economies.

Impact of Different Option Plans on Compensation

      Stock Price Increase Stock Price Decrease
  Stock Price Year 1
$100
Year 2
$150
Year 3
$200
Year2
$65
Year 3
$30
Fixed value plan

Options granted
Value of Options
Cumulative Value

28,128
1 million
18,752
1 million
14,0641 million
5.4 million
43,2731 million 93,7591 million
1.3 million
Fixed number plan

Options granted
Value of Options
Cumulative Value

28,128
1 million
28,128
1.5 million
28,128
2 million
7.2 million
28,128
$650,000
28,128
$300,000
$510,000
Megagrant plan

Options granted
Value of Options
Cumulative Value

79,697
2.8 million
0
0
0
0
8.1 million
0
0
0
0
$211,000

Option Values are derived using the Black-Scholes model and reflect the characteristics of a typical but hypothetical Fortune 500 company; the annual standard deviation of the stock price is assumed to be 32%, the risk-free rate of return is 6%, the dividend rate is 3%, and the maturity period is ten years.

Excerpted from The Venture Capital Cycle, MIT Press, 1999.

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