05 Nov 2001  Research & Ideas

Venture Capital Goes Boom—or Bust?

In The Money of Invention: How Venture Capital Creates New Wealth, HBS professors Paul Gompers and Josh Lerner demystify the role VC plays in the economy. Read an excerpt. Plus: Q&A with the authors.

 

Ninety percent of new entrepreneurial businesses that don't attract venture capital fail within three years.

A software engineer at the government contractor EG&G, Don Brooks had been working on computer systems for the Idaho National Engineering and Environment Laboratory, a Department of Energy facility, when he suddenly had a brainstorm that he knew would help him as well as others solve an all-too-common problem. 1 Using the "gopher" technology that had long made the exchange of files and programs across mainframe devices possible, in 1991 Brooks developed a way for one computer to access data stored on another and to interact with that information. As he publicized his innovation among his fellow employees and across the computing community, people admired the quality of his work. In fact, in head-to-head comparisons, his software program garnered ratings far superior to those of Mosaic, a similar tool then under development at the University of Illinois. Reviewers of Brooks's prototype raved about its ease of use and reliability. The engineer felt certain that, with EG&G's backing, his idea would soon be a major success in the marketplace.

But his hopes were not realized. Four years later, another company working on the same technology went public to great acclaim and fanfare. The firm? Netscape Communications, under the leadership of Marc Andreessen and Jim Clark. 2 Because its new product was based on the Mosaic technology developed at the University of Illinois, Netscape became embroiled in a messy intellectual-property dispute. Despite these challenges, on its first day of trading, Netscape soared to a market capitalization of $2.1 billion.

Why did Andreessen and Clark succeed where Brooks failed? Part of the answer lies in the role of Netscape's initial financiers, the venture capital firm Kleiner Perkins Caufield & Byers. While Brooks struggled to interest EG&G in backing his concept (EG&G considered Brooks's idea outside its core business), Kleiner Perkins moved decisively to fund the fledging Netscape, realizing that market timing was critical to the success of the new venture. In addition to providing financing and advice on product development, marketing, and finance, Kleiner introduced Netscape to key Silicon Valley players, as well as the investment banking teams at Morgan Stanley and Hambrecht & Quist. Even more telling is that Jim Clark, cofounder of Netscape, had been a highly successful entrepreneur at Silicon Graphics and could have easily financed the firm himself. Instead, he understood the value that Kleiner Perkins could bring to Netscape. Lacking such assistance, Brooks soon fell far behind his rivals.

Like Brooks, most high-technology entrepreneurs are convinced that their ideas hold immense promise. Often, their excitement is well founded. An innovative product or new service concept may have enormous market potential and may far outperform competitors' alternatives. Moreover, the intellectual talents of the founding team may be stellar.

The Money of Invention: How Venture Capital Creates New Wealth

However, many of these entrepreneurs discover they need to attract money to fully commercialize their concepts. Thus they must find investors—such as their own employer (if the idea was created while on staff), a bank, an "angel" financier, a public stock offering, or some other source. But potential investors often greet entrepreneurs' business plans with skepticism, or worse, turn them down entirely. Alternatively, some investors demand a large equity stake in the project and tight control rights in exchange for a modest sum of money.

Before the emergence of the venture capital market, the vast majority of entrepreneurs seeking financing from traditional sources failed to realize value from their ideas. Indeed, many product or service innovators privately (and sometimes publicly) referred to investment professionals as "vulture capitalists." These entrepreneurs' frustrations are understandable: Most financiers do not understand the fragile growth process that start-ups experience.

But entrepreneurs themselves have also contributed to their own financing problems. Many of them simply don't have a clear picture of the risks inherent in their business models—risks that pose some serious concerns for potential investors—or they lack a thorough understanding of the four basic problems that can limit financiers' willingness to invest capital, which we outlined in the introduction to this section:

  • Uncertainty about the future
  • Information gaps
  • "Soft" assets
  • Volatility of current market conditions

All companies must grapple with these difficulties, but young, emerging enterprises are particularly vulnerable to them, as these problems limit their ability to receive value from their ideas and innovations. This chapter will help both entrepreneurs and potential investors understand these financing hurdles and the various mechanisms that can be used to reduce potential conflicts that arise due to these four factors.

There's no getting around it: Innovation is risky business.
— Gompers & Lerner

Uncertainty about the future

There's no getting around it: Innovation is risky business. All entrepreneurial individuals and companies face uncertainty about the future—not only in terms of their own development possibilities, but also in terms of market and industry trends. 3 But a word of caution: Many people who are interested in the investment world confuse uncertainty with that which is unknown or unknowable. In the case of something that is unknowable, no amount of research or analysis will lift the fog. However, for young, entrepreneurial firms, uncertainty doesn't have to mean unknowability. Rather, uncertainty can be viewed as a measure of the distribution of possible outcomes for a company or project. The greater the uncertainty, the wider the distribution of potential outcomes.

This distinction between uncertainty and unknowability is critical. A careful analysis of a particular entrepreneurial project can identify key phases of uncertainty, yield a list of potential outcomes of each phase, and provide an assessment of the likelihood of those various outcomes. This kind of thoughtful review constitutes the first step in determining a project's financing alternatives.

Five Questions for Paul Gompers and Josh Lerner

HBS Working Knowledge contributor Carol Elsen conducted an e-mail interview with Paul Gompers and Josh Lerner about their new book, The Money of Invention: How Venture Capital Creates New Wealth.

Elsen: Since the dot-com implosion, how has the venture capital industry changed? For example, do venture capitalists want more from their clients in terms of an ownership stake or in terms of meeting tougher performance benchmarks?

Gompers and Lerner: Many of the changes in the venture capital industry over the past eighteen months have been cyclical in nature. Just as what happened after previous booms, we have seen the impositions of tougher standards by venture capitalists when examining whether to fund or refinance companies, a decrease in the valuations assigned to these firms, and a slowing of the frenetic pace of investment. It is likely that we will also see a slowdown in fundraising by venture groups in the upcoming years, as well as an imposition of tougher terms on venture groups by the institutions who are their primary sources of capital.

At the same time, there have been some fundamental changes happening in the venture capital market in recent years that are quite different from these cyclical patterns. In the book, we discuss how a confluence of factors—the changing sources of capital, the rise of intermediaries, and the growing concentration of investors dollars—is likely to lead to some fundamental changes in the venture capital industry in the years to come.

What are the implications for entrepreneurs seeking funding given the current uncertain economic climate?

The bad news is that raising money today is clearly much tougher than it was twenty-four months ago. Venture groups are much more skeptical of what they are seeing, and many of the most exuberant—or perhaps we should say foolish!—investors from that period have dropped out of the market entirely. Being realistic about the market and the terms on which capital will be offered is thus very important for entrepreneurs.

At the same time, some of the most successful venture capital-backed companies have been financed during previous downturns in the venture capital market. Entrepreneurs should not necessarily abandon all hope. Venture capitalists still have many, many billions to invest, so well crafted business plans can get funded. Moreover, new firms are less likely to encounter numerous imitators, as often was the problem in the late 1990s, when the funding of "me too" firms became commonplace.

Is the nature of the venture capitalist changing? That is, if Arthur Rock and John Doerr each represent earlier generations of venture capitalists, what are the attributes of the next generation? Likewise, how is the nature of the overall venture capital business changing today? What characteristics will mark the next generation of firms in the future?

We believe that the venture capital industry today is in the midst of a profound transformation. The venture capital sector has historically followed what might be termed the "craft" model: Procedures were very unsystematized, and venture groups were loosely organized. We believe that over the next decade, it will move to much more of a "professional" model.

We believe these changes will have a variety of important consequences. First, the structure of the industry will shift. The scale and influence of many of the leading firms in the industry will increase. These changes will also have implications for the role of the venture capitalist. Rather than being a largely independent actor, the venture capitalist will increasingly become a team player, coordinating the firm's resources to help portfolio firms.

What are the opportunities and challenges for international venture capital efforts?

For its first fifty years, venture capital (as opposed to private equity, or buyout investing) was a very American activity. Efforts to transplant the model were few and far between, and these efforts were usually unsuccessful. It is easy to see why it is hard to create a new venture capital industry "from scratch." To be successful, a nation needs an ample supply of promising new technologies, a set of knowledgeable managers willing to take risks, helpful regulatory and tax conditions, and robust markets in order to exit investments.

Despite these challenges, the past few years have seen a surge of venture capital activity abroad. While some of these efforts may have had more "sizzle than substance," elsewhere, real venture industries are being established. The changes in Germany, India, and Israel over the past half-dozen years are perhaps the most dramatic. In each case, real value has been created by new ventures, and these successes have in turn spurred cultural, economic, and regulatory changes that make continuing venture capital success in these markets likely.

Who is your target audience—who can benefit by reading The Money of Invention and why?

Our book has three goals: First, it seeks to explain how the venture capital industry has historically worked. Entrepreneurs often have misconceptions about the role that venture capitalists play in new ventures. Our book provides a framework for entrepreneurs to understand the venture capital process. But rather than emphasizing an excessively rosy or dour view, we seek to present a balanced perspective. We highlight both the powerful ways in which the venture industry has worked, as well as the distortions that periodically grip the industry. This is geared to those who would like to get a comprehensive and systematic introduction to the industry's workings.

Second, many efforts have been launched in the past decade to "transplant" the venture model: to adapt the key features of the venture capital approach within large corporations, academic institutions and hospitals, and nations without a strong entrepreneurial tradition. Many of these efforts have been costly failures. The book seeks to provide guidance to would-be "emulators"—corporate managers, university administrators, and policy makers—about how to adopt the best of venture capital and avoid the common pitfalls that frequently entrap the unwary.

Third, the book seeks to map out the likely future evolution of the venture capital industry, and the strategies that venture capitalists can take to insure that their organizations succeed in today's new and challenging era. Many venture capitalists today are grappling with these issues.

Footnotes:

1. The story of Don Brooks's development of his Internet browser is based on interviews with Brooks and his colleagues in July 1996.

2. The rise of Netscape and the role of Marc Andreessen, Jim Clark, and Kleiner Perkins Caufield & Byers are drawn from W. Carl Kester and Kendall Backstrand, "Netscape's Initial Public Offering," Case No. 9-296-088 (Boston: Harvard Business School, 1996).

3. The importance of uncertainty in decision making is discussed in Daniel Khaneman, Paul, Slovic, Amos Twersky, eds., Judgement Under Uncertainty: Heuristics and Biases (New York: Cambridge University Press, 1982).

Excerpted with permission from The Money of Invention: How Venture Capital Creates New Wealth, Harvard Business School Press, 2001.

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