Five Questions for Paul Gompers and Josh Lerner

by Carol Elsen

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.

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

A: 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.

Q: 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?

A: 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.

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

A: 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.

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

A: 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.