Done Deals - Mathias

Excerpted from the book Done Deals, edited by Udayan Gupta, Harvard Business School Press, 2000

I have been around venture capital, in one way or another, for almost thirty years. This has included being a buyer of the venture capital product while an investment manager, forming and managing venture funds, and being active as a private investor in numerous start-ups and early-stage situations. The latter has required hands-on involvement, which broadly translated in my case has meant helping raise money or dealing with personnel or strategic problems. My background differs significantly from most other practitioners in that I come to this arena with much more of a macro view and public market orientation.

It's been fascinating to experience the industry's growth and its cycles, all of which have occurred in a relatively short period.

	The successful venture investors in the past were really people who had ideas, made a leap of faith, and then worked tobuild companies. Process was not that important.
	— Ed Mathias

Remarkably, a large number of the participants who created the industry and sustained its growth are still alive and active.

A Cottage Industry

Early on, venture capital was a cottage industry and certainly not a glamour business. Looking back to the late '60s and early '70s, wealthy individuals, SBICs, banks, and insurance companies were the major participants. There was a lot of money raised coincident with the technology craze and speculative markets of the late '60s, but it was nothing like the industry we know today. There were relatively few participants, the pools of capital were small, and everyone seemed to know each other and work together. In those days, the industry totaled perhaps $1 billion in aggregate. Venture activity peaked in 1969 as the market reached a major top and the capital gains tax was increased, I believe, to 49 percent. A five-year bear market and the destruction of small company valuations followed.

My own indoctrination to entrepreneurship started with my father, who was an active small businessman and investor. In the Navy, I was a Supply Corps officer, in effect running a small business onboard a destroyer. I was formally introduced to venture capital at Harvard Business School in 1970. A number of my classmates were interested in small business opportunities, and the course Starting New Ventures with Pat Lyles, who later went on to be an active partner at Charles River Ventures, was exceedingly popular.

The companies we studied seem mundane by today's standards. People typically started on a shoestring and usually financed growth with positive cash flow over a long period. The most distinctive memory I have is of families coming to class with the husband — since mostly men started companies in those days — saying how great it was, and the wife saying what a disaster it had been to live through.

At the same time, we were confronted with stories of General Doriot. His legacy played a major role at Harvard Business School, although he had retired by the time I got there. Everybody talked about Digital Equipment Corporation (DEC) and the fact that American Research and Development (ARD) had turned something like $70,000 into $400 million by the time DEC was sold to Textron.

Between my business school years, I worked with a classmate on two mundane ventures that gave me additional insights. One idea was to consolidate beauty shops. The other involved providing leased equipment to Blue Cross Blue Shield. Neither of these went anywhere, but the experience proved highly worthwhile and, importantly to me, the individual for whom we worked happened to be a senior person at T. Rowe Price Associates. This relationship indirectly led to my choice of a career and my first job.

T. Rowe Price and NEA

I joined T. Rowe Price Associates in 1971, as did Chuck Newhall, who later went on to establish New Enterprise Associates (NEA). At the time, T. Rowe Price was a small firm but an established leader in small public company investing. The New Horizons Mutual Fund, managed by Cub Harvey, was one of the only public vehicles focused on emerging-growth stocks. Chuck Newhall was charged with preparing T. Rowe Price to enter the venture business, and I joined as an investment counselor, or portfolio manager. Through a total fluke, as seems to characterize most careers, I ended up house-sitting with Cub Harvey during my first summer. He subsequently asked me to work on the New Horizons Fund, which turned out to be an extraordinary opportunity and one that greatly influenced my future. Chuck also worked on the fund, establishing what we termed as an incubator portfolio, which was devoted to very small public companies. His efforts were to be a prelude to T. Rowe Price Associates launching its own venture capital product.

About this time, having an entrepreneurial itch, a friend and I established a chain of ice cream stores. As a result of the riots following Martin Luther King's death, none of the established firms would go near the inner city. We tried to take advantage of this, and let's say, charitably, that we lost a small amount of money and a lot of time. Our failure resulted primarily from not selecting and being willing to pay for premier real estate locations.

At the time, although it wasn't readily apparent, there were significant structural changes occurring that would lay the groundwork for venture capital's growth. The Nasdaq was created, and this eventually provided a robust public marketplace for small companies. ERISA was passed in the mid-'70s, which over time enabled fiduciaries to diversify into assets other than bonds and large blue-chip equities. ERISA didn't have much of an initial impact, but down the road it proved to be extraordinarily important.

As institutions became more aggressive and adventurous, a number of regional brokerage firms emerged which were very much oriented to technology and venture capital. Firms such as Hambrecht & Quist, Robertson Stephens, and Montgomery Securities come immediately to mind. Alex. Brown, with its long history, sensed the opportunity and positioned itself to participate. The firms were primarily in California, and came to play a powerful role. Initially, a lot of them had extremely close, sometimes incestuous, relationships with the venture community.

T. Rowe Price Takes a Stab at Venture Capital

From the depths of the bear market in 1974, the investment environment began to improve. In 1977, T. Rowe Price tried to establish a venture capital arm. At the time, though, there were some real problems with the Securities and Exchange Commission in terms of whether a registered investment advisor could have a profit participation or a carried interest. Also, the idea that one element within a large firm oriented to public securities could invest in venture capital with the principals having a direct profit participation raised significant internal issues. Finally, given the problems trying to do this internally, we worked with the potential partners and created New Enterprise Associates (NEA). The initial partners were Chuck Newhall from T. Rowe Price and Frank Bonsal, a legendary deal finder or "bird dog" at Alex. Brown. Finally, NEA attracted Dick Kramlich, who had been Arthur Rock's partner and was a friend of Cub Harvey's. Dick wanted to stay in San Francisco and thus NEA became bi-coastal. T. Rowe Price became a special limited partner, and forged a long-term relationship that proved to be mutually beneficial. It seems hard to comprehend in light of today's conditions, but NEA struggled mightily to raise $15.6 million. I recollect that there were only two other funds raised that year. Had it not been for a fortuitous event in which a Midwestern family put up close to $5 million, I question whether NEA would have gotten off the ground.

In any case, that was the start of New Enterprise Associates and my direct involvement with traditional venture capital. As it turned out, it proved to be an extraordinarily opportune time to start a venture capital fund. New technologies were coming rapidly to the forefront and this — coupled with a shortage of capital, experienced investors at the ready, low public valuations, and time in which to build companies — created a great investment opportunity. Together with the clarification of ERISA, the growth of Nasdaq, and an advancing market, this set the stage for the ensuing boom years.

Coincidentally, the capital gains rate was reduced, thus providing a further impetus for investment. Venture capitalists have always considered the capital gains rate extraordinarily important, not just for the investors but as related to their ability to attract and motivate workers. As we've come to see, the incentive compensation system with a heavy emphasis on options that venture capital spawned now permeates the U.S. economy.

We began to see a number of leaders emerge in the venture community. Some of the early venture capitalists who come to mind include Peter Brooke, Arthur Rock, Tommy Davis, and the principals at Kleiner Perkins, Sutter Hill, and Mayfield. Interestingly, a number of the early firms have grown and maintained their preeminent positions. On the institutional side, GTE, IBM, General Electric, Harvard Management, AT&T, and the Hillman Family, among others, were early to the game and laid the path for others to follow.

T. Rowe Price was fortunate in attracting Paul Wythes, an extraordinarily successful venture capitalist at Sutter Hill, to join the board of the New Horizons Fund. We felt that Paul would be useful in helping us understand the industry and in providing a perspective that differed from our public market vantage point. This certainly proved to be the case, as his inputs and contacts proved invaluable.

The late '70s and early '80s were still a period in which not a lot of money was being raised by today's standards. There were something like seven new partnerships in '79 and perhaps ten in 1980. But as the market started to advance, people started to see the spectacular returns being achieved by the venture capital partnerships. This stimulated interest, with the result that around 100 venture funds were raised over the next three years. Much of this was institutional money, primarily from private pension funds, which had begun to grow enormously.

By the early 1980s, venture capital had become significant — not within the context of the overall financial markets, but in terms of its impact. The industry then had almost $7 billion under management. Venture capitalists raised almost $900 million in 1981 alone. The stock market rebounded strongly starting in the summer of 1982, and from 1983 to 1985 we had an IPO boom of then-unprecedented strength. This enabled venture realizations, created an outstanding performance record for venture capitalists, and permitted them to raise more money. Almost $4 billion was raised in 1983. Throughout this period, the pension market came to see venture capital as an increasingly attractive asset class and as the mutual fund industry grew, there was tremendous interest in owning shares of venture companies that became public.

High-Tech Investment Bankers: The Four Horsemen

One cannot consider this period without mentioning what came to be known as the "Four Horsemen." This group, which issued a majority of the hot technology deals, included Robertson Stephens, Alex. Brown, Hambrecht & Quist, and Rothschild, Unterberg & Towbin. Bill Hambrecht was something of a cult hero at the time — not only did he run one of the most powerful firms, but he was also one of the most visible venture capitalists. His name alone would generate a lot of interest. The Hambrecht & Quist conference, dating back to the early '70s, became extremely popular as a gathering place for public and private investors.

At T. Rowe Price we watched what was going on and decided that it would be an opportune time to launch what was then called a mezzanine fund, which would invest in companies just prior to their public offering. Previously, brokers had often given these deals to favored clients, or had formed what then were called bridge funds to participate. Now, big institutional clients that generated large brokerage commissions wanted a seat at the table. We raised approximately $80 million for the T. Rowe Price Threshold Fund. At the same time, Hal Bigler,1 working with Rogers Casey,2 a then-prominent pension consulting company, launched a similar fund called Crossroads. Today, this is a well-defined segment and numerous such later-stage funds exist.

We soon learned that you could not invest in deals by simply piggybacking on top of brokerage or venture capital relationships. Doing your own work was critical. Most of all, this brought home the real differences between the public and private markets. There are basically no regulations in the private market — it's caveat emptor. Also, terms have to be negotiated, as opposed to being pre-established. Unlike a public company, there is much less credible and analyzable data. Finally, there is virtually no liquidity in problem situations. As a portfolio manager, I could always get some bid on a public company. For private companies, if there were a major problem, it often would require a great deal of work, additional funding, or simply pulling the plug. None of this is particularly fun, and the time drain can be substantial.

It turned out that what was happening during this period, as is often the case, was that many were putting money in at a peak. Too much money had come into the market and venture prices had increased greatly based on public valuations. If you look back, it's interesting to see that the funds formed in the '83 to '87 period, with few exceptions, provided returns that were significantly below historic norms. In general, the venture capital returns from this period proved to be considerably less than 10 percent annualized. This highlights the cyclical aspects of the industry, something that today seems to have been forgotten.

During this time, as the funds experienced growth and became institutionalized, a myriad of unanticipated issues began coming to the fore. Were venture capitalists holding public stocks and getting paid venture fees? Were they distributing at the top with the stocks immediately going down after distribution? Did the brokers know about the distributions and were they somehow taking advantage of this to front-run clients? 3 What were the internal conflicts and those between different funds within the same organization? Internal issues pertaining to the general partner's operation also came under scrutiny. There were no easy answers and a number of the issues remain relevant today, although the industry has developed many standard guidelines and accepted practices to deal with them.

Venture capital again peaked in terms of fund-raising in 1987 following the bull market and ensuing IPO boom. Performance is historically followed, with a delay, by money into venture capital. Coincident with the '87 market peak, the venture industry raised $4 billion. For perspective, and as further testimony to the historic cyclicality, fund-raising declined to $1 billion in 1991 as performance of the mid-'80s funds lagged. There was virtually no IPO market, with the cumulative amount of IPOs from 1988 to 1990 being less than was done in 1986 alone. I believe after the crash in 1987, there was only one deal done for the balance of the year.

I remained at T. Rowe Price, but as the '80s progressed, I became increasingly interested in private equity. As competition increased, I could see it was becoming increasingly difficult for individuals to distinguish themselves in the public market. As a frame of reference, when the New Horizons Fund started in the late '60s, we were one of two or three small-company institutional investors. In the mid-'90s there were almost 500 emerging-growth mutual funds, not to mention other pools of capital available for this purpose. Despite what people say about venture capital and competition, it's still a business characterized by huge inefficiencies where the practitioners continue to live by their wits and relationships. Also, the opportunity to distinguish yourself is just enormous if you can build companies that grow into substantial enterprises. It really struck me that the differences between the creation of wealth and simply money management, along with the fee structure and the appeal of a profit participation, would lead talent toward venture capital and other forms of private equity.

The '90s: Venture Capital's Golden Age

As the '90s dawned, venture capital was poised for a major resurgence. This was to mark the beginning of what became the golden age of venture capital—a period unlike any we have ever seen in terms of the build-up of assets, wealth, and enterprise value. We had a great backdrop: a rising stock market, low inflation, falling interest rates, good economic growth, and lots of liquidity. Add to that yet another change to the capital gains tax, which had risen in '87 to equal the tax on ordinary income and was now reduced to a much lower level.

Venture capital by now had become an accepted institutional asset class. There were large amounts of new money seeking superior performance and diversification. It was also an exciting place to invest. The institutions also liked the way the accounting was done, eliminating volatility by holding values relatively constant. This was a time when tax-free investors began to truly dominate the market. In addition, the baton was passing slowly from the traditional defined-benefit plans of major corporations to state and local governments, which were funneling enormous sums of money into this arena. As an example, the State of California allocated billions of dollars to alternative assets and became a significant force in the marketplace.

All in all, it was a very hospitable environment. We again started to see new, exciting industries emerge — networking, wireless communications, the Internet, and others. What we have seen — and continue to see — is that the venture community is a very good allocator of investment capital. When the need was for hardware, that's where the money was going. When networking and the Internet took off, venture capital was there. It's interesting that if you track venture capital flows, you track the growth areas in the U.S. economy.

Expanded Venture Capital: A New Structure

Once again, the industry started to take on a new structure. As institutions played a much more prominent role, gatekeepers, fund-of-funds, secondary markets for partnership interests, and so on, came into being. The infrastructure developed as venture firms grew larger and the bigger investment banks began to show more interest in their output. Venture capital began to get much more recognition as the business press focused on it and high-tech millionaires were highly publicized. Venture capitalists even began taking on a political role concerning issues that were important to them. However, I think it is important to note that in the overall context of the financial markets or alternative assets the amount of venture capital is not all that significant. Leveraged buyout and real estate funds are much, much larger, and their impact even greater if you consider the use of financial leverage. However, it can be argued that venture capital has far more impact in terms of job creation and economic growth.

I decided to leave T. Rowe Price in 1993. I liked the idea of becoming more focused on private equity, working with smaller companies without having to worry as much about potential conflicts of interest, and being involved with young entrepreneurs. In doing so, I wanted to remain active, be taken seriously, have a credible platform, and work in smaller situations where it would be possible to make a difference. I was fortunate to have a number of opportunities that enabled me to move in this direction. I had been instrumental in founding The Carlyle Group, a Washington, D.C.-based merchant bank, and this provided me an outstanding platform from which to operate. At the outset, I helped to establish and become a special limited partner at Trident Capital, a venture pool focused on information systems, and assisted in the founding of several other funds. I also invested directly in a number of individual deals — some in conjunction with venture firms, others not. My whole idea was to spread out, get into the traffic, and establish a lot of interlocking relationships. I saw myself as something of a server, in computer parlance, where a lot of things would come my way, and I would distribute them to others and then figure out how to participate in one way or another. As an interesting sidelight, Jim Clark gave me one of the first looks at Mosaic — which subsequently became Netscape and is now part of AOL. I missed participating for a variety of reasons, but this opened my eyes early on to the Internet's potential and led me to a number of related investments, including iVillage and Wit Capital.

An Angel in the Beltway

As contrasted to most venture capitalists, I have had to repackage myself at a relatively late stage in my career and shift focus from a primarily public market orientation. What has evolved is an extraordinarily exciting and challenging multifaceted role. As time went on, I helped establish and now oversee The Carlyle Group's venture capital pool, with assets now totaling well above $500 million. I am also a special limited partner in a number of other firms and serve on other advisory committees. This outreach program gives me a window on industry conditions, provides deal flow, and generates a wide range of personal contacts.

Probably the most interesting — and challenging — thing has been private investing in individual companies. I don't like to use the word angel — it seems almost too benign. I was fortunate early on in tapping in with a few young entrepreneurs outside the traditional venture capital world. Through a series of circumstances, I had become acquainted with Jon Ledecky, who early on promoted the concept of consolidating or rolling up industries. I became the first investor in U.S. Office Products, which soon went public and eventually reached over $4 billion in revenues. I also became involved in several other companies — USA Floral and Sirrom Capital — that quickly went public.

As a private investor, I see a number of relatively small situations with people who do not want, for a variety of reasons, to go the traditional venture route. A lot of those deals are too small for the large funds, creating opportunities below the so-called radar screen. This, together with the wealth creation of the '90s, has led to the development of the angel networks. You cannot fail to be impressed with the amount of activity that's taking place at this level. In some ways, these bands of angels are disintermediating, or at least competing with, traditional venture capitalists.

This occurs in a period during which we are starting to see an evolution in the world of venture capital. We have gone through a tremendous boom — an unprecedented creation of wealth. This has been accompanied by an explosion in the aggregate amount of venture capital raised. New Enterprise's first fund was $16 million in 1977. Their most recent fund, NEA-9, is over $800 million and the next fund is expected to far exceed $1 billion. Billion-dollar venture pools, unthinkable just a few years ago, are becoming almost commonplace. Large institutional investors continue to allocate small percentages, which amount to extremely large dollar amounts, to the area. The preference for well-established firms or brand names that can effectively manage large money is quite remarkable. The large firms have more than maintained their market share.

There exists a tremendous aversion to first-time funds. To me, this represents an inefficiency in the market. I have personally tried to get involved with them and found this to be financially and professionally rewarding. Typically, those with a first fund are experienced, motivated people that either have a new idea or a proven expertise. The amounts of money are small, which tends to better equate with high rates of return. There's no doubt that such funds are highly focused and dependent upon establishing an outstanding record to ensure the viability of their firm.

We are also seeing something of a redefinition of the traditional venture capital system. There's less camaraderie, less syndication, less sharing of information, and more geographic dispersion. The large firms have a much harder time funding and working with very early-stage companies. With size comes an inviolate trade-off: more deals or bigger deals. It's now not just competition between firms, but also competition from small investors who are no longer really that small. That's particularly true in technology, where tremendous amounts of wealth have been created. This, together with high prices in the public market and the funds available to traditional venture firms, is driving up valuations. Today, entrepreneurs are much more knowledgeable and sophisticated in terms of selecting partners and setting the financial terms for their deal. The ample availability of funding, together with intense competition for deals, fosters this kind of environment.

Marketing Venture Capital: Gaining a Competitive Edge

Venture firms are now confronted increasingly with the issue of how to establish competitive advantage. We are seeing various responses to that as the industry matures and segments. Many firms now have more of an industry focus. There have been numerous other responses, including a regional focus, the incubation of start-ups where venture capitalists originate and nurture an idea, the use of platform companies as a basis for consolidation, housing entrepreneurs in residence, the allocation of small amounts for overseas investment, and so on. Also, we see numerous major corporations spraying large sums around. Both Microsoft and Intel have put significant amounts of money into individual companies, not so much to earn a financial return but for strategic purposes. Other technological companies such as Oracle and MCI WorldCom have recently announced moves in this direction. There's no reason to think such activity will diminish.

New hybrid models have also emerged. One that immediately comes to mind is Roger McNamee's Integral Partners, which has used his knowledge of the public market and a relationship with Kleiner Perkins to forge a new type of firm that invests in both public and private companies. Roger worked with me at T. Rowe Price and has been very innovative in identifying market opportunity. Recently he established Silver Lake Partners, the first firm to focus on technology buyouts.

We have been in an environment where an amazing number of big companies — most of which came out of the venture capital community — have been created. Cisco, Yahoo!, Amazon, CIENA, eBay, and innumerable others have come out of nowhere and emerged as leaders in rapidly growing — and often new — markets. The speed at which this has been occurring has not been lost on venture capitalists, and it has had a dramatic impact on the industry. Today's venture funds have become much larger and the rapidity of investment has increased exponentially. There is almost an inexhaustible appetite for capital, as many deals — particularly in telecommunications — require substantial funding. The potential for wealth creation within the venture community has become enormous. With over $120 billion of allocated capital in the venture business today, the derivative incentive compensation (based on a 20 percent-plus profit participation) is almost mind-boggling. It is also important to note that, when you look at the number of highly successful companies and initial public offerings, the preponderance of such companies that have been venture-backed is quite remarkable. While venture money may be the tip of the iceberg within the financial markets, it really has driven the IPO market and been a significant force propelling the U.S. economy.

Paying for Venture Capital

Some things, however, have not changed. Perhaps most significant is the venture capital fee structure. This was put in place to solve very specific problems and has endured. In many ways it is no longer as relevant to today's business with many organizations layering funds and managing huge amounts of money. Nonetheless, it's been impervious to very strong pressures from the institutional community and today we even see the best funds increasing to either a 25 or 30 percent carried interest. Perhaps the reason for this is a perceived shortage of top-flight venture capitalists that can effectively manage large sums of money. Such firms have not had to bow to the fee pressures that have hit other parts of the investment management industry. Also, Silicon Valley continues to be dominant. The region has the capital, the technology, the role models, the major universities, and the infrastructure. We've recently seen pockets of venture capital emerge in other areas such as the northwest, Texas, and the mid-Atlantic region. But while vibrant, they pale in comparison to Silicon Valley. Overseas there have been fledgling efforts to establish venture capital centers, but this remains primarily a U.S. phenomenon.

Today the industry has become institutionalized in a way that none of us could have imagined thirty years ago. However, it has not become larger in the context of the financial markets of the U.S. economy, where $40 billion of annual funding and total assets exceeding $100 billion are relatively small sums. That would suggest that this is an industry that still has room to grow and attract more capital.

Initial Public Offerings: Venture Capital's Crunch Factor

As I look back over history, the IPO cycle remains a point of particular fascination and importance. There is overwhelming evidence that most people don't make money in new issues. But the infatuation comes and goes, and periodically provides the window that allows the realization of huge value for venture capital. As I look back on my career, one of the most interesting things is how investors react to hot new issues. A love affair with the new, and the idea of getting in on something exciting with huge potential and some scarcity value, 4 seems to be eternal. The underwriters and the companies are very good at whipping up enthusiasm for new issues. This can be an extraordinarily important component of venture capital returns, although over longer periods perhaps two-thirds of venture companies are sold or merged rather than taken public.

The new issue market is not just a factor in realized returns. It provides a very inexpensive form of capital for companies, which in turn provides a huge competitive advantage for the new companies that can obtain it. I've always looked at the financing cycle of venture capital companies as being something like an accordion. It expands and compresses based on the availability of public capital. If the public markets close, you have various rounds of financing at fairly expensive prices. When there's a very robust new-issue market, capital can be extraordinarily inexpensive. Thus, we see opportunities come and go in various stages of the financial cycle as a result of stock market conditions and the outlook for new issues.

Despite its success and widespread appeal, the industry is not without challenges and issues, both for investors and practitioners. Performance, truly spectacular in recent years, is always a question mark and a challenge. It goes without saying that expectations today are extremely — perhaps unrealistically — high. Venture firms are dealing with increasingly large sums of money, and current public and private valuations have risen dramatically. Historically, such conditions have augured a period of lower returns, although this is counterbalanced today by an abundance of opportunity in the U.S. economy. There are also generational issues facing the industry, as the people who built the firms are migrating to other areas, or taking on more limited roles. Another important question is: Will institutionalization lead to sterility? The successful venture investors in the past were really people who had ideas, made a leap of faith — not an intuitive judgment, but an instinctive reaction to people and ideas — and then worked to build companies. Process was not that important. More and more, it seems that venture capitalists are acting like traditional money managers rather than investors. This is something that I saw happen as the money management business grew and became institutionalized. It poses a true danger to the larger firms and could provide an opportunity for smaller, aggressive new entrants.

Looking ahead, it seems that the risks in venture have gone up as a result of high valuations, an abundance of capital, and increased competition. This should eventually result in lower returns than those experienced in the late '90s. However, there is no reason to think that venture capital will not continue to provide superior rates of return over longer periods. There seems no shortage of new ideas nor of those willing to take an entrepreneurial risk. When you look at the number of companies that have been formed over the last four or five years, a tremendous pipeline of opportunities exists. There is a huge need for venture capital to sustain and grow these companies. Interest is growing on the part of individuals and institutions, and this should provide adequate funding for the foreseeable future.

As in the past, some cyclicality in returns and funding levels seems inevitable, but the industry looks to be on very solid ground. Clearly, there's no reason to be discouraged about the long-term outlook for venture capital. It remains a great business, and I can't imagine a better career venue.

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