ROUNDTABLE ON U.S. RISK CAPITAL AND … · WILLIAM BYGRAVE is the Frederic C ... is the Fred H....

JOURNAL OF APPLIED CORPORATE FINANCE48

CONTINENTAL BANK JOURNAL OF APPLIED CORPORATE FINANCE48

DON CHEW: Good afternoon, and welcome to the

First Annual Roundtable on Risk Capital and Innova-

tion. (It may also be the last, of course, but I’m hoping

it will have a successor.) My name is Don Chew, and

I will serve as co-moderator of this discussion along

with Bill Petty and John Martin, the principal organ-

izers of this session. I am Editor of the Continental

Bank’s Journal of Applied Corporate Finance. The aim

of the Journal is to “translate” outstanding research in

corporate finance—conducted primarily by academ-

ics at our business schools and published in academic

journals—into reasonably plain English for corporate

executives. It attempts to provide a meeting ground

for theorist and practitioner by stressing the practical

import of the research.

With this aim in mind, I would like to use this

discussion to give people in the business world a

look at the thinking and research now going on at

our universities and business schools on the subject

of venture capital—or, to use the more inclusive

term, risk capital. Stated as broadly as possible, the

main issues are these: What is happening today in

U.S. venture and other risk capital markets? What do

we know about how the functioning of these

markets affects the economy at large? And, can we

use some of the practices of our own risk capital

markets to help in the ongoing transformation of

Eastern European economies?

ROUNDTABLE ON

U.S. RISK CAPITAL

AND

INNOVATION

(WITH A LOOK AT

EASTERN EUROPE)

Sponsored by the

Financial Management Association

and

Baylor University

Chicago October 9, 1991


Another promising line of inquiry is to ask whatlessons from venture capital can be applied to thefinancial management of our large public corpora-tions. For example (and I’m betraying my ownbiases here), some corporate finance scholars, no-tably Michael Jensen, have argued that the LBOphenomenon represents an on-the-whole success-ful application of some of the principles of venturecapital—especially concentration of ownership andintensive monitoring by a financially interestedboard—to the management of mature public com-panies. More recently, Jensen has also argued thatthe “overshooting” and boom-bust cycle experi-enced by the LBO market were likely caused by a“contracting failure”—that is, by a rather grossmisalignment of incentives between the LBO spon-sors and the limited partners who provided thefunds. And, as Jensen himself suggested, this kind of“contracting” problem may well explain the recentboom-bust cycle and thus part of the currentlydepressed state of the venture capital market.

The practices and conventions of our venturemarkets may also contain at least partial solutions tothe problems faced by our largest companies inraising capital—especially the credibility gap withinvestors that academics have called “informationalasymmetry,” but also the so-called “agency cost”problem, the separation of ownership from controlthat reduces the value of many of our largestcompanies. Large public companies may also beable to learn from venture capitalists in funding andstructuring their own R&D and other growth invest-ments. For example, before the changes in tax lawbrought about by the Tax Reform Act of 1986, R&Dlimited partnerships appeared to be providing a tax-efficient vehicle for importing the entrepreneurialspirit into the corporate R&D effort.

This discussion has been set up to fall into twodistinct parts. In the first—and by far the longer ofthe two—we will talk about current developmentsin U.S. risk capital markets. Where is the moneycoming from for new ventures? How is that chang-ing, and why? How much does the capital cost, andhow are the deals structured? In the second part, wewill try to extend some of the insights from U.S.venture capital practice to current developments inEastern Europe.

Venture capital alone clearly is not the answerto the problems of Eastern European economies.Perhaps the major information “asymmetry” nowdiscouraging foreign investors is one that only

government policymakers can correct—that is, theabsence of well-defined property rights. But, on thebasis of what we know about U.S. ventures, is theremuch in the private sector alone that can be doneto stimulate new business development in theEastern bloc countries? The privatization of stateenterprise is also expected to play a major role intransforming these economies. So, to what extentcan the conventions of our own venture markets beexported both to create new businesses and to bringabout stronger incentives for improved efficiencywithin state-owned businesses?

To discuss these issues, we’ve assembled agroup of people that represent a variety of perspec-tives and experience. And I’ll now introduce them.

GORDON BATY

is the Managing Partner of Zero Stage CapitalCompany, a well-known venture capital firm basedin Cambridge. He has over 20 years of experiencein the formation, financing, and operation of newhigh-technology firms. Gordon was the founder andCEO of two early-stage, high-technology companiesthat he later sold to Fortune 500 corporations. Heholds a Ph.D. in Finance from MIT and his latestbook is Entrepreneurship for the Nineties (Prentice-Hall, 1990).

WILLIAM BYGRAVE

is the Frederic C. Hamilton Professor of Free Enter-prise and academic coordinator of entrepreneurialstudies at Babson College. Bill’s current researchinterests center on high-potential start-ups, and heis the co-author of a book on venture capital that willbe published by the Harvard Business School Pressin 1992. Like Gordon, Bill also has considerableexperience in the formation of high-tech ventures;and he served on the investment committee of theMassachusetts Capital Resource Company, a state-supervised venture capital fund. Bill, by the way, hasled a double academic life, earning a Ph.D first inphysics from Oxford and much later a doctorate inBusiness Administration from Boston University.

PATRICK FINEGAN

is a Partner of Stern Stewart & Co., a corporatefinance advisory firm specializing in corporate plan-ning, valuation, restructuring, and value-based in-


centive compensation. Pat leads Stern Stewart’sindustrial consulting practice for smaller and privatecompanies.

KENNETH FROOT

is the Thomas Henry Carroll-Ford Visiting Professorat the Harvard Business School, where he teachesfinance. Ken has been a consultant to many interna-tional companies and official institutions, includingthe International Monetary Fund, the World Bank,and the Board of Governors of the Federal Reserve;and he is currently serving as adviser to the PrimeMinister of the Yugoslav Republic of Slovenia.

THOMAS GRAY

is currently Chief Economist of the Small BusinessAdministration, where he has worked since 1978.His major duties include the development of a smallbusiness economic data base, and the supervision ofresearch on the following areas: structural changesin small businesses in response to changing demo-graphics; small business adoption of new technolo-gies; and the relationship between small businessdevelopment and the efficiency of the Americaneconomy.

JOHN KENSINGER

is Associate Professor of Finance at the University ofNorth Texas. John has published widely on corporaterestructuring and innovations in corporate organiza-tional forms such as R&D limited partnerships, projectfinance, and network organizations. John is also co-author of Innovations in Dequity Financing.

GARY LOVEMAN

is Assistant Professor at the Harvard Business School.His research focuses on changes in both the demandand supply side of labor markets, and the humanresource management issues posed by these changes.Gary is also currently involved in a field study ofprivate small business development in Poland.

STEPHEN MAGEE

is the Fred H. Moore Professor of Finance andEconomics at the University of Texas at Austin. Hehas served on the Economic Advisory Board to the

U.S. Secretary of Commerce and the National Sci-ence Foundation Advisory Committee for Econom-ics. Steve’s primary research interest is the effect oflaw and regulation on economic efficiency andgrowth. He is currently a visiting professor at theUniversity of Chicago.

JOHN MARTIN,

one of my co-moderators in this discussion, is theMargaret and Eugene McDermott Centennial Profes-sor of Banking and Finance at the University ofTexas at Austin. John has written four books, as wellas a number of articles on financial planning,corporate restructuring, and the impact of legal andorganizational issues on financial management.

BRUCE PETERSEN

is Associate Professor of Economics at WashingtonUniversity, and was formerly a senior economist atthe Federal Reserve Bank of Chicago. His areas ofresearch include industrial organization, public fi-nance, and the microfoundations of macroeconom-ics. Bruce is especially interested in the question ofhow the choice of internal versus external financingaffects corporate spending on capital investmentand R&D.

WILLIAM PETTY,

my other co-moderator, is Professor of Finance andthe W.W. Caruth Chairholder in Entrepreneurship atBaylor University. Bill’s research publications havebeen focused in the area of corporate finance, witha developing interest in entrepreneurial finance.

WILLIAM WETZEL

is the Forbes Professor of Management at theUniversity of New Hampshire’s Whittemore Schoolof Business, and also serves as Director of theSchool’s Center for Venture Research. His profes-sional and research interests include the role of theentrepreneur in economic development, the finan-cial management of high-growth private compa-nies, and the functioning of informal venture capitalmarkets. Bill also founded and serves as presidentof Venture Capital Network, Inc., a not-for-profitcorporation designed to assist entrepreneurs infinding venture capitalists.


PART I: DEVELOPMENTS IN THEU.S. VENTURE CAPITALMARKETS

CHEW: Let me start by asking BillWetzel to give us a working definitionof “risk capital.” How is that differentfrom the venture capital market mostof us are familiar with? And can youtell us a little about who you think arethe major players in this market, howmuch money they have to contributeto entrepreneurs, and what sorts ofactivities they like to fund?

In Search of Angels

WETZEL: I’d like to start off by con-fessing, as Don did earlier, that myown biases are going to be reflectedin my statement of the issues. Thearea I know most about in venturecapital is the so-called “angel” mar-ketplace (which I will get to in aminute), although I’m not unac-quainted with the other aspects ofthe venture capital business.

But first let me say that the set ofissues surrounding innovation in busi-ness and technology—and the role ofventure and other forms of risk capitalin stimulating the process of innova-tion—is just absolutely critical to theeconomic future of this country. In themost recent President’s EconomicReport to the Nation, it was pointedout that innovation and its diffusionaccounted for over half of the increasein our standard of living over the lastcouple of generations.

It should also be pretty obvious bynow that our large established corpo-rations are no longer the primaryengine of economic growth. Duringthe 1980s—and this was well beforethe current recession set in—ourFortune 500 companies lost some-thing on the order of four millionjobs. Over roughly the same period,our smaller companies created some-thing like 17 million net new jobs. On

the basis of these two numbers alone,I would submit that this country’sentrepreneurs and its high-risk inves-tors—and our success in strengthen-ing the connection between thesetwo groups—constitute one of ourvital competitive edges in world mar-kets. It’s an edge we need to maintainin the face of global changes thatcould very quickly erode that com-petitive position.

Now, in thinking about what, ifanything, we ought to be doing froma public policy standpoint to encour-age the formation of risk capital, it’suseful to begin by identifying boththe principal innovators or entrepre-neurs—that is, the potential users of

the risk capital—and the investors, orthe suppliers of that capital. There areseveral distinct groups of both inno-vators and investors, and I’d like toattempt to set up some categories forclassifying members of each of thesetwo groups.

The innovators—the ventures thatare creating the jobs, the new tech-nology, the products, while also pay-ing taxes and increasing exports—can usefully be divided into fourcategories: (1) unaffiliated, individ-ual inventors; (2) start-up ventures;(3) large, established technology-based companies; and (4) non-profitorganizations such as universities andteaching hospitals.

By far the most productive amongthese four groups, I would argue, arethe firms that fall within the secondcategory—that is, the start-up ven-tures. Now, I suggest we can usefullytalk about three classes of start-ups:First is what I call “lifestyle ventures”—these are firms whose sales potentialis limited to, say, $10 million. Secondare what I call “middle market ven-tures”—those that have the potentialto be a $50 million company in arelatively short period of time, but thatare likely to remain privately ownedrather than going public or beingacquired by a larger company. Al-though these companies are relativelyinvisible, they in many ways consti-tute the backbone of the economy.They are the real workhorses in thejob-generating process. And, third andfinally, we come to the “high potentialventures”—firms whose growth po-tential is likely to go well beyond $50or even $100 million within five yearsof starting out. These are the morevisible companies, and they are theones institutional venture capital fundstend to focus upon.

Now, to give you some idea of therelative contributions of these vari-ous classes of innovators, let me citesome numbers I’ve appropriated from

I would suggest there are aquarter of a million activeangels in this country—thatis, self-made high-net-worthindividuals who, to somedegree, will help fund thenext generation ofentrepreneurs in the U.S. Iwould guess that they investannually somewhere between$20 and $30 billion, which isat least 10 times the amountinvested by institutionalventure funds... As theinstitutional funds continueto reduce their already smallcommitment to early-stageseed financing, we ought todo everything we can to availourselves of the knowhowand the capital that are in theminds and the pocketbooksof the angels.

—Bill Wetzel—


the work of David Birch. Birch hasconcluded that there are on the orderof 50,000 new start-ups in this coun-try every year. And about 5% of thesetotal start-ups would fall into one ofthese two larger start-up categoriesthat I’ve called “middle market” and“high potential” ventures.

With respect to existing compa-nies, Birch has pointed out that, ofthe roughly 10 million “small busi-nesses” in the country, over 500,000are growing faster than 50% per year.And some recent surveys lend sup-port to Birch’s estimates. For ex-ample, the median annual growthrate of Inc. magazine’s list of the 500fastest-growing private companies inAmerica is something like 95% peryear; the 500th firm on the list isgrowing at 65%. So those companiesare out there, and they’re doing someremarkable things. But they tend notto make the headlines.

Birch has attempted to translatethese kinds of numbers into an an-nual venture capital requirement—or at least into an annual equitycapital requirement—that is, theamount necessary to fund all of theseinnovators. His estimate comes out inthe range of $50 to $100 billion a year.And, that, I think, sums up the impor-tance of the question we’re dealingwith here today. That is, where is thecapital coming from to finance thispotentially very large group of inno-vative ventures?

Let me now turn from the users tothe sources, the providers, of riskcapital. Here I’m going to talk justabout two sources: (1) the formalinstitutional venture capital funds and(2) the informal or angel market Imentioned earlier.

As you all know, there have beensome disturbing trends in the institu-tional venture capital market. Lastyear, for example, there was onlyabout $2 billion invested by the insti-tutional venture funds—which

amounts to about half a day’s tradingvolume on the New York Stock Ex-change. And that money was in-vested in only about 1,000 compa-nies. (Remember, Birch is talkingabout half a million companies thatcould use something on the order of$50 billion.) Also disturbing to me isthe fact that, of the 1,000 companiesreceiving venture capital funding, only250 were getting venture backing forthe first time. The rest were follow-onfundings of companies already inventure capitalists’ portfolios. And,perhaps even more troublesome, only$60 million dollars, or 3%, of theventure capital invested last year wentinto seed and start-up deals.

The professional venture funds, tobe sure, never really have gottenmuch involved in financing genuinestart-ups, but they’re even less into itnow. So, the issues I would raise arethese: What are the causes of thecurrent trend in venture capital? Andcan that trend be reversed, perhapsby enlarging the pool of funds cur-rently available for venture capital-ists? And if the answer is no, thenwho’s going to bankroll our nextgeneration of entrepreneurs?

The second source of innovativerisk capital that I’d like to talk aboutis the “angel” marketplace, or theinvisible providers of risk capital. Idefine angels as primarily self-made,high-net-worth individuals who areunaffiliated either in a family or mana-gerial sense with the ventures theyback.

To give you some sense of theimportance of angels to new busi-ness growth, I will just quote verybriefly from last Sunday’s Boston GlobeMagazine. In an article entitled, “BabyBoomers to Inherit Vast but UnevenWealth,” the author says, “By far thebiggest financial gains from inheri-tances are likely to come not from thestock market but from parents whoowned or started their own firms.”

One of my favorite pastimes islooking at Forbes’ portraits of the 400richest people in the U.S., the annualridiculous edition that comes outevery October. I’m interested in itbecause I’m curious as to where thewealth comes from in these megabuckfamilies. At the top of this year’s listyou’ll find Henry Kluge, the Germanimmigrant who founded Metrome-dia. Number two is Bill Gates, the 35-year-old founder of Microsoft, with anet worth of something like $4.8billion. And third is Samuel Walton,an entrepreneur in the middle ofArkansas, who has also accumulateda fortune of incredible dimensions.The average net worth of the peopleon that list is $720 million; the bottomone is $275 million. Now, if you addup all this wealth, the people listed inthe Forbes 400 alone represent a poolof capital of $288 billion dollars!

Now, with respect to the entireangel marketplace, which of courseextends well beyond the Forbes 400,I will cite the following data—and Ican say this with some confidence,because nobody can prove me wrong;there just aren’t any sources of reallygood data, which is one of the troub-les with research in this area.

On the basis of this admittedlypreliminary data, I would suggestthat there are a quarter of a millionactive angels in this country—that is,self-made high-net-worth individu-als who, to some degree, will helpfund the next generation of entrepre-neurs in the U.S. I would guess thatthey invest annually somewhere be-tween $20 and $30 billion, which is atleast 10 times the amount invested byinstitutional venture funds. To besure, the angels put that money out inmuch smaller chunks than do con-ventional venture capital firms. Iwould also estimate that the numberof companies receiving backing fromangels is probably on the order of80,000 to 100,000.


Using data we collected at ourCenter for Venture Research, welooked at sources of funding for newtechnology-based firms that werefounded in New England between1975 and 1986—that is, during theheydays of the venture capital indus-try. And we found that over 80% of theangel deals involved the commitmentof less than half a million dollars. Inthe same period, only 13% of theventure fund deals were in that sizerange. Whereas the median angel dealwas $150,000, the median venturecapital deal was in excess of a million.Equally important, whereas 60% ofthe angel deals were seed or start-updeals, only 28% of the institutionalventure deals were start-ups.

So, let me summarize this phe-nomenon by proposing that the angelmarketplace is really not a competitiveor alternative marketplace to the insti-tutional marketplace, but rather acomplementary one. I would alsoargue that, as the institutional fundscontinue to reduce their already smallcommitment to early-stage seed fi-nancing, we ought to do everythingwe can to avail ourselves of the kno-whow and the capital that are in theminds and the pocketbooks of theangels. Because it’s this group of indi-viduals, not the institutional venturefunds, that really are the farmers ofAmerican industry. They are plowingand seeding the ground for the nextgeneration of entrepreneurs.

So the issues I would raise herewith respect to angels—and, again, Iconsider them absolutely critical tothe future of our entrepreneurialeconomy—are as follows: How manyactive angels are really out there? Aretheir investment decision models dif-ferent from those of the venture funds?And let me tip my hand by saying Ithink that they are quite different. Ithink the angels respond to somepersonal “hot buttons,” if you will.I’m convinced they get “psychic in-

come” that prompts them to behavein ways that are significantly differentfrom venture fund managers who aretrustees for other people’s money. Isuspect they have greater tolerancefor risk and perhaps longer timehorizons than conventional venturecapital fund managers.

And I will bring this peroration toa close by suggesting that the activeangels in this country are probablyoutnumbered by what I call “virginangels”—that is, potential ventureinvestors—by about five to one. Andthus a very pressing issue for me is:How do we convert these virginangels into streetwalkers?CHEW: Bill, we know that the insti-tutional venture capital market isdown from a high of about $4 billionin 1987 to less than a billion this year.What, if anything, do we know aboutcurrent trends in the angel market?WETZEL: We don’t have the data yetto be able to say. We are now in themiddle of collecting it. But my senseis that the angels have become moreactive as the venture market has gonedown.CHEW: But doesn’t that suggest thatthe two groups of investors are notjust complementary markets, as yousaid? They may also function in partas “substitutes.” The angels may bepicking up the slack, funding some ofthe opportunities now being passedover by the institutional venture capi-talists.WETZEL: Yes, I agree. I think that’shappening to some degree.CHEW: Also, Bill, what you are call-ing the angels’ hot buttons or psychicincome may also be reflections ofwhat economists call lower “informa-tion costs.” Having angels instead ofventure fund managers provide capi-tal for start-ups may well be a highlyefficient way of overcoming the largeinformation costs that confront any-body trying to raise outside capitalfor risky ventures. In many cases, I

would guess that the angels eitherknow the entrepreneurs personally,or they understand the business ofrunning start-ups because they’vedone it themselves.WETZEL: That’s right. Angels typi-cally fund people they know work-ing in fields they know.

The SBA Looks at Angels

TOM GRAY: We at the Small BusinessAdministration were fortunate enoughto work with Bill when he first startedmeasuring the angel market. We havedone a number of follow-up studiessince then, and I would like to usethese studies as a basis for expandingon several points that Bill made.

In particular, I think this informa-tion issue that Bill and Don haveraised is absolutely critical to howthese risk capital markets work. Andit’s not so much information costs Ihave in mind, but what I would callthe positive, or synergistic, informa-tion benefits that often arise from theunion of investor and entrepreneur.In the angel venture market, inves-tors often provide not only capital,but also their own expertise. Fromour studies, it appears that investors’willingness to commit their capitalseems to depend on their own indus-try-specific knowledge, or on theirfamiliarity with the particular market-place that the venture is aimed at. Theinvestors are bringing much morethan their wealth, they’re also bring-ing knowledge.WETZEL: That’s right, they’re value-adding investors.GRAY: I would also agree with Bill’sstatement that there appears to begrowth of activity in this angel mar-ketplace, even as the institutionalmarket continues to decline. TheFederal Reserve does a survey on anirregular basis of the wealth status ofAmerican individuals. They surveywhat they call “well-to-do” families,


those with annual incomes of over$100,000. And one of the findingsthat’s truly startling to me is that overhalf of those families own at least apartial interest in a business. Thesepeople either have a family or per-sonal business, or they are angelinvestors in other people’s busi-nesses—or both. In fact, a lot of thesepeople fall into the “both” category.CHEW: That must include a lot ofphysicians and dentists?GRAY: Sure. But, the evidence alsosuggests that 80% of angel investorsare themselves entrepreneurs. They’renot just wealthy people, they’repeople who have launched their ownbusinesses. And that’s what I meanwhen I say the angels are bringingknowledge to the market. By andlarge, the angel market is a matter ofentrepreneurial people funding otherentrepreneurs. To use Don’s termi-nology, this has got to reduce infor-mation costs.WETZEL: Let me add that there’s evi-dence that 80% of the millionaires inthe U.S. are self-made entrepreneurs.And this supports my contention thatthere’s a large stock of untappedangel capital in this country.

Hurdle Rates in Venture Capital

BILL PETTY: Bill, there was a recentarticle in the Wall Street Journal,which cited your work, where theauthor presented a pretty compellingcase for the relationship between thecapital gains tax and the level ofentrepreneurial investments. As partof the article, the writer described thefour basic risk capital markets: (1)professional venture capitalists, (2)initial public offerings, (3) angels,and (4) mom-and-pop operations.Drawing on Commerce Departmentand Federal Reserve figures, heclaimed that in 1986 these four mar-kets produced about $180 billion innew entrepreneurial investments. He

further estimated that the make-up ofthese markets were two percent fromprofessional venture capitalists (afterremoving leveraged buy outs andacquisitions), 13 percent IPOs, 23percent from angels, and 62 percentfrom the moms and pops of theworld. However, by 1990, the $180billion market was thought to beabout $90 billion—half of its formersize of only four years earlier, with noapparent change in the make-up ofthe market.BRUCE PETERSEN: These numbersjust confirm my suspicion that thegreat preponderance of risk capital inthis country is internally generated; itdoesn’t come from outside sources.

In fact, internal finance has probablyalways been the dominant form offinance for high-risk start-ups, withinstitutional venture capital account-ing for a fairly minor share of thatmarket.

And I don’t believe that’s about tochange much either. If we can believeBill Sahlman’s recent article on ven-ture capital in the Journal of Finan-cial Economics, venture capitalistsare using discount rates in the rangeof 40-60% in evaluating new projects.Such high discount rates probablyreflect not only the great uncertaintyand risk of such ventures, but alsomajor information asymmetry andmoral hazard problems. Rememberthat if entrepreneurs know a lot moreabout their chances of success thanthe people they’re asking to fundthem, this can lead to an adverseselection problem in which venturecapital investors get stuck with adisproportionately large proportionof losers. For this reason, venturecapitalists may rationally require 40%rates of return on individual projects.

Such high hurdle rates would inturn explain why venture capital playssuch a limited role in start-up ven-tures. It just doesn’t seem to me thatmany projects can pass that kind of atest. It doesn’t appear that many ven-ture capital deals are going to getdone if those are the kind of discountrates they need to break even.CHEW: What are the discount ratesfor angels, Bill? Is there a survey thattells us they will accept expectedrates of return as low as, say, 25%because they personally know thepeople and the process they’re work-ing with?WETZEL: I’m going to go out on alimb here. I think angels are verymuch like venture capitalists in thatthey don’t want to lose money. They’rejust as diligent in investigating thedownside risks. But I believe theyattach more weight to the upside

From our studies, it appearsthat investors’ willingness tocommit their capital seems todepend on their ownindustry-specific knowledge.Our evidence also suggeststhat 80% of angel investorsare themselves entrepreneurs.They’re not just wealthypeople, they’re people whohave launched their ownbusinesses. And that’s what Imean when I say the angelsare contributing much morethan just their wealth, they’rebringing their knowledge. Byand large, the angel market isa matter of entrepreneurialpeople funding otherentrepreneurs. And, to useeconomists’ terminology, thishas got to reduce informationcosts.

—Tom Gray—


potential; this is what I mean by the“psychic income” I mentioned ear-lier. I think that if an entrepreneur canstrike a deal with an angel, whetherit’s a woman looking for financing foran inner-city venture, or a new tech-nology that the investor knows some-thing about, the cost of that capitalwill be significantly lower than if youhad to go to a venture capitalist.

So, I will go out on a limb and sayangel money is cheaper as long asthere’s a good match between thehot-button or psychic dimensions ofthe deal.GRAY: Our evidence suggests thatmost angels are satisfied to earn 20 to25% per annum on their entire port-folio—and that’s based on the as-sumption that they’re going to losehalf their investment in three out ofevery ten cases.CHEW: But that’s not much differentfrom our historical experience withinstitutional venture capital, is it?Haven’t venture capitalists earnedaveraged returns of between 20%and 25% over long periods time?WETZEL: Actually, many probablyonly wish they had earned 25%.PETERSEN: Yes, but you’re gettingaway from my point here. My under-standing is that that 25% is an ex postrate of return. That’s what they earnedin fact on the entire portfolio. Myquestion is about what they expect toearn on successful projects in orderto get that 25% return on their totalportfolio.GRAY: We asked the angel investorsthis ex ante question. What kind ofreturns are you looking for when yougo into these deals, and their answerwas 20% to 25%, which we thoughtwas amazingly low.WETZEL: Was that independent ofthe stage of the deal?GRAY: Well, these people were mainlymaking first-stage investments. About60% of the investments were firststage.

PETERSEN: But if what you’re sayingis true about these lower angel dis-count rates, then that leads me toquestion even more the efficiency ofthe institutional venture capital mar-kets. Bill Sahlman’s study suggestsventure capitalists are applying exante discount rates of 40% to 60% toindividual deals, partly out of fearthey may be getting more than theirshare of lemons. Venture capitalistsmay need this “lemons premium,” ifyou will, to ensure they will earn ahigh enough rate of return on theirwinners to make up for their losses.And I’ve got to believe these kind ofdiscount rates are denying fundingfor a lot of otherwise viable projects.

KEN FROOT: Well, it’s not clear tome what these information asymme-tries are in the case of new ventures,and whether there really is a potentialadverse selection problem. Now, Iagree that a medium-size companywith a choice between the debt orequity markets might have adverseselection properties associated withit. That is, if the company’s manage-ment thinks the stock is overvaluedbased on it’s view of the future, thenit will come to the equity marketinstead of raising debt. And the mar-ket is well aware of that incentive. Infact, that’s probably the main reasonwhy stock prices fall—by about 3%,on average—when new equity offer-ings are announced.

But, in the case of venture capital,you can only get that kind of adverseselection if the entrepreneur with theidea has somewhere else to go forcapital. So, it doesn’t seem likely thatventure capitalists are getting morethan their share of the lemons. They’reprobably getting all of them, goodand bad alike—except perhaps forthe ones who happen to have anangel, or happen to be pretty richthemselves.

So this brings us back to the ques-tion: Why are venture capitalists ask-ing for 50% returns? I don’t know theanswer to that. But there may besome confusion here about whetherthat 50% is really an expected return.My suspicion is that Sahlman is reallyreporting expected returns condi-tional on succeeding. In other words,venture capitalists are probably say-ing to entrepreneurs, “Show me abusiness plan that, if it succeeds, islikely to deliver 50% per annum.Because I have all this downside risk,I need 50% returns on my winners toget my total portfolio return of 25%.”PETERSEN: Well, I’m not convincedthat venture capitalists really are get-ting all the entrepreneurs, good andbad alike. A 1990 study by Barry,

Bill Sahlman’s study suggeststhat venture capitalists areapplying ex ante discountrates of 40% to 60% toindividual deals, partly out offear that they may be gettingmore than their share oflemons. Venture capitalistsmay need this kind of“lemons premium,” if youwill, to ensure they will earna high enough rate of returnon their winners to make upfor their losses. Such highhurdle rates would alsoexplain why venture capitalplays such a limited role instart-up ventures. I’ve got tobelieve these kind of discountrates are denying funding fora lot of otherwise viableprojects.

—Bruce Petersen—


Muscarella et al. in the Journal ofFinancial Economics reported thatonly a minority of all firms that wentpublic in recent years made any useof venture capital. So, I don’t thinkyou can so easily dismiss the possibil-ity of a serious adverse selectionproblem here, especially given thefunctioning of this alternative angelmarket Bill’s described.

Measuring Rates of Return inVenture Capital

BILL BYGRAVE: I’ve done a gooddeal of research in this area, and letme warn that you’ve got to be carefulwith these surveys and especiallywith self-reported rates of return. Iwas sitting in a room at Harvard oneday in 1988 with people that repre-sented about one third of venturecapital in America. And Bill Sahlmanhad these people fill out a question-naire in which they were asked toproject over the next five years boththeir own portfolio’s rate of returnand the average rate of return of theentire industry. The most interestingfinding to me was that these fundmanagers thought that, although theirown realized rates of return would beabout 25%, the industry rate of returnwould be 15% or less.

Another case in point: In the sum-mer of 1983, Congress did a survey ofsome 250 venture capital firms. Inthat survey, the fund managers saidthey expected to earn between 30%and 40% per annum over the next fiveyears. The actual returns reported bythose same firms over the next fiveyears turned out to be in the range of12% to 14%.

So, self-reported numbers are ex-tremely unreliable. It’s a bit like brag-ging rights. Fund managers need toproject high rates of return in order togo out and raise their next fund. Youwant to be able to say that you’reexpecting to earn 30% on your fund

because 15% is not enough to im-press the pension fund managers.CHEW: Do all the studies of venturecapital suffer from this self-reportingbias?BYGRAVE: No, they don’t. Thanks toVenture Economics, we’ve got theactual numbers now; we’ve got ratesof return with high statistical reliabil-ity. I helped Venture Economics setup its returns database, the numberswere checked carefully, and we wentto great lengths to make the sampleof firms representative.PETTY: And what do the numbersindicate?BYGRAVE: Well, if you throw all theventure capital firms together, thenthe median annual return since 1986is actually below 10%. But this broadaverage is not very meaningful. Theyear a given deal got its start seems tohave been critical in determining itssuccess, and thus it’s more instructiveto break out the returns by whatventure capitalists call “vintage,” orwhat economists call “cohort.”

What we’ve found, for example, isthat many of the funds started in 1978earned better than 40% rates of re-turn. 1978 was a wonderful year tostart. There was a shortage of venturecapital then, and there were a lot ofnew technologies just becoming com-mercial. Microprocessing was one.Biotechnology, although not com-mercial, was beginning to excitepeople. So there were a lot of entre-preneurs ready, as it were, to beinvested in. And we also had thiswonderfully hot over-the countermarket in the early 1980s, whichpeaked in the first half of 1983. Thisenabled many of the deals in the late’70s to make their exit by goingpublic and thus earn their 40%.

But each generation of funds sincethen has earned progressively lowerrates of return. And, frankly, most ofthe post-1985 funds are down in thesingle digits, some are negative, and

some are even going to fail. If they dofail, I believe they will be the firstfailures in the 45-year history of thisindustry.

Venture Capital Contracts andThe Boom-Bust Cycle

CHEW: Is this a normal competitivecycle, the kind where you seem in-evitably to get too many players chas-ing too few good deals?GORDON BATY: I don’t think we’vebeen around long enough as anindustry to say what’s normal. I thinkwe’re looking at a bunch of first-timephenomena.CHEW: But, given that everybodyexpects the other guy to earn 15% orless, isn’t it the general perception ofthe industry that there are too manyplayers?BATY: I’m not so sure that’s the casenow. That was certainly the percep-tion about three years ago. But be-cause of the recession and a numberof other sort of exogenous factors,the industry has changed a lot. Youcertainly don’t have as many dealsnow, and you have a lot fewer play-ers. Even those funds with significantamounts of liquidity are sitting on itbecause they know they’re going tohave great difficulty in raising thenext pool.CHEW: But, I thought the peak forventure capital deals came back in1987, well before the recession?BATY: That’s right, and that was theinterval when you in fact had toomany dollars chasing too few deals.CHEW: Gordon, my understandingis that venture capitalists like yourselfthat serve as general partner and putthe deals together typically put uponly about one percent of the eq-uity—and the limited partners supplythe rest. It thus seems to me that thedealmakers don’t really bear muchdownside risk; it’s all been put offonto the limited partners. Is it con-


ceivable that this problem of toomany deals could be corrected bymaking the venture capitalists put upmore of the equity—say, as much as5 or 10% of the deal?BATY: I very much doubt that youcould get the general partners to putup 10% of these huge pools. I thinkthat it’s a problem that would be moredirectly addressed by showing somedecent returns so that we could attractmore professionals into the industry.CHEW: But wouldn’t this possiblyhelp reassure investors—some ofwhom may have already been burnedonce—if the general partners went tothem and said, “Look, I’m putting 5%of my own capital on the line to showyou that my interests are closelyaligned with yours”?BATY: I don’t think it would havemuch of an effect. Although there aresome wealthy venture capitalists whocould do that, they don’t represent alarge fraction of the population.

But, as I said, I think there areprobably other ways that you couldachieve that same effect if that werea major concern. For example, thelimited partner investors are increas-ingly insisting on a minimum rate ofreturn—at least a Treasury rate ofreturn—before the general partner isallowed to share in any upside. That’sone mechanism that the big pensionfund managers are increasingly in-sisting on.CHEW: But the general partners stillget their management fee every year,don’t they? And that’s not based onperformance, it’s just a fixed percent-age of the amount invested.BATY: Yes, but even that is under alot of pressure.CHEW: Really? That’s interesting.BATY: It’s happening.BYGRAVE: The gatekeepers arechanging the industry.BATY: That’s exactly right.BYGRAVE: By “gatekeepers” I meanpeople like Stan Pratt, who take one

percent for taking money from lim-ited partners and then choosing afund like Gordon’s to invest thatmoney in. This trend has broughtsome standardization of the manage-ment fee and compensation struc-ture. Today, for example, the capitalgains residuals are almost alwayssplit 80/20 between the limited andthe general partner.

But, Don, to come back to yourpoint, I don’t understand why youneed this extra equity from the gen-eral partner. I would have thoughtthe 20% participation in the upsidewould have been more than enoughmotivation for Gordon to go and doa great job for me.

CHEW: Well, it gives him an upsideoption, but it doesn’t force him tobear any downside risk. And, as Ithink we saw from our experience inthe LBO markets, this gives somedealmakers—the marginal players, ifyou will—financial incentives just todo deals, even when the payoffs arenot likely to be there.BYGRAVE: I don’t agree with that. Ithink the downside risk is that he’sgoing to want to raise another fund,and his ability to raise that fund willdepend on the rates of return heprovides his limited partners. So, thereis a real downside here: Who wantsto employ another unsuccessful ven-ture capitalist these days? They’re adime a dozen.BATY: Yes, we would have to go outand get a real job then. And that’s anasty business.CHEW: Okay, but this reputationeffect, if you will, doesn’t seem tohave prevented some dealmakers inthe LBO and HLT markets from over-paying, from doing a lot of unecon-omic deals. Only a few firms in theLBO market today seem to be work-ing hard to salvage their reputations.

Gordon, would you agree that theventure market could conceivablyhave produced some players withshort horizons—people who had al-ready raised some money and werewilling to do deals just to break intothe business and get some of theirlimited partners’ money invested?BATY: I doubt it.CHEW: I asked the wrong person.GARY LOVEMAN: Don, you might beinterested to know that one of thelargest U.S. venture capital opera-tions today invests 10% of the capitalin any venture capital pool they man-age for pension funds. And if you askthem why they use their own capital,they say it’s essentially for the rea-sons you’ve just mentioned.CHEW: I would assume that kind ofstatement is very helpful in raising

If you’re an entrepreneurtoday, it’s literally harder nowthan it would have been in1981 to raise your firstmillion dollars to get acompany off the ground. Onan inflation-adjusted basis,there’s probably 20% fewerdollars under managementfor seed and early-stageventures....

If there were some new kindof liquidity mechanism—something akin to whatSalomon did in the early ’80sto securitize house mortgages,some way to securitize abundle of venture capitalpartnerships—this wouldhelp reduce this largeilliquidity premium that’srestricting venture capitalinvestment today.

—Gordon Baty—


money from the limited partners, es-pecially in the current environment.LOVEMAN: That’s right, they are say-ing that they’re in the deal finan-cially as well as emotionally withtheir limited partners; that’s very clearfrom the terms of the contract.CHEW: Is there any sign that they arehaving more success in raising moneythan the average venture capitalist?LOVEMAN: I’m not an expert on this,but my sense is that they’ve donevery well. They certainly haven’t hadany problem raising money. And we’retalking about several billion dollarsunder management.

Angels and Capital Gains Taxes

BATY: There’s a whole raft of inter-esting things that Bill Wetzel raised inhis opening remarks that I think areworth returning to. One I’m acutelyconscious of is this fact that the amountof institutional money committed toseed and start-up deals has actuallygone down in the last decade. So youhave this enormous paradox: If you’rean entrepreneur today, it’s literallyharder now than it would have beenin 1981 to raise your first milliondollars to get a company off the ground.On an inflation-adjusted basis, there’sprobably 20% fewer dollars undermanagement for seed and early-stageventures.

Many of the people with the skillsand experience of putting togetherand financing early-stage technologystart-ups have gone out of the busi-ness entirely. They’ve discovered it’sa lot easier to make a living runninga $400 million fund than running a$40 million venture capital fund. Andthere’s just no way on earth youcould possibly make 400 individualinvestments in million-dollar start-ups—which is about the average ini-tial investment in this business.

So it is a source of concern. Theangels do have to take up the slack.

Bill, you said you thought you per-ceived more angel activity now thanperhaps in earlier years. And thatpuzzles me a little, especially giventhat we now have no capital gains taxdifferential. It’s been pretty well proventhat capital gains doesn’t affect any-thing in the institutional world. But, inthe world of angels, I would think thatcapital gains taxes are very important.What tax impact do you see, if any, onthe proclivity of angels to invest today?WETZEL: Well, the tax impact is aquestion not of direction, but of de-gree. Clearly angels respond nega-tively to increased capital gains taxes.But the work I’ve done, or am familiarwith, seems to indicate that the effectof taxes is relatively marginal in thecontext of the entire investment deci-sion. But, that does not mean thatcapital gains taxes are not hurtinginvestment. One of the most insidiouseffects of the capital gains tax—andthis will not show up in the statistics—is that it effectively locks up a signifi-cant part of the capital that mightotherwise have been liquidated andthen moved into other kinds of invest-ment, including start-up ventures.PAT FINEGAN: I disagree. The capitalgains tax is more likely to affect thestructure of angel-financed deals thanthe availability of financing. Most“angels” are themselves successfulentrepreneurs with their own privatecompanies. By adopting a holdingcompany structure, they often plowotherwise taxable distributions fromtheir core business into promisingangel-like ventures.

The point is, unlike a large pub-licly-held company, where a purelydiversifying investment adds no valueif it can be replicated individually byits shareholders, many private com-panies avoid double taxation bymanaging individual portfolio deci-sions at the corporate level. Also, byentrusting a series of otherwise inde-pendent investment decisions by pas-

sive family members to one steward,the CEO, fear of double taxation andof recognizing capital gains may actu-ally extend the group’s investmenthorizon, inclining it toward more ven-turesome angel-like investments.

Of course, not all such ventureswill make Bill’s census of angel deals,since many are structured as unincor-porated business units, product ex-tensions, or divisions. And those thatdo make the list may have poorerodds of success than ventures fundeddirectly by individuals if (1) they holdout less equity participation for theventure’s managers or (2) they exer-cise less than arm’s-length restraintwhen advancing additional funds tothe venture.

Where I see problems with thecapital gains tax is in its second ordereffect—perpetuating holding periods.Because cashing out is so expensive,many of the private companies Iwork with have evolved into mini-conglomerates containing lots of whatwere once angel ventures—many ofwhich have foundered for want ofdiscipline or incentives, or been sus-tained only by repeated uneconomiccross-subsidies. In many private com-panies, diversification becomes soexpansive, so ingrained, that it givesrise to significant “agency” problems.The tensions can become so fierce insecond and third generations thatactive and passive family membersliterally tear the company apart.WETZEL: Let me make one othercomment on this issue of capital gainstaxes. Economists have estimated thatthe public or social rate of return oninvestment in technological innova-tion is at least twice the private rate ofreturn. So there’s a compelling reasonfor public policymakers to stimulatethis kind of investment. And, withminimal impact on the federal reve-nues, I believe we could target acapital gains tax differential to encour-age direct equity investment in seed-


capital or in smaller venture typedeals. I’d offer as a model SenatorBumpers’ proposed bill, which saysthat if an investment is held five yearsor longer, the gains tax drops to halfthe current rate; and if you hang ontoit for ten years, it drops to zero. So, ifwe really believe that this is theengine that drives our economy, weought to establish a capital gains taxdifferential for investment in start-upand early-stage companies that isdesigned to unlock more of this pent-up angel capital.

The Social Returnsfrom Innovation

PETERSEN: Bill, what is the evidencethat social returns from technologicalinnovation are twice private returns?WETZEL: Well, a secondary source isthe President’s Economic Report tothe nation back in 1989. The primarysource I have in mind was a study byEdwin Mansfield, an economist atPenn, who looked at some 18 inno-vations. And, although I don’t recalleither the nature of the innovationsor the time period, Mansfield re-ported that the “social ROI,” if youwill—and, not being an economist,I’m not sure how he measured this—was over 50%, while the private ROIwas in the 25% range.PETERSEN: I have seen several otherstudies. Zvi Griliches has written awhole book on this, published by theNational Bureau of Economic Re-search, that also finds very high ratesof return from innovation. This large“wedge” between the social and pri-vate returns from private investmentis thought to be the result of a diffu-sion or spillover effect. The innovat-ing companies can’t appropriate allthe gains from their own innova-tions. And I think this inability toappropriate gains confronts all typesof technology investments, not justthose funded by venture capital.

FINEGAN: I would guess that theprincipal beneficiaries of innovationsare the customers of the innovatingcompanies. Take the case of thecomputer industry, where the pricesof these high technology productscoming out of Boston have fallenvery rapidly.CHEW: Can someone tell us a littlebit about how economists measurethese gains?FROOT: It’s actually a matter of look-ing at chunks of areas under demandcurves where technologies lead toprice reductions and quantity in-creases. Some of the gains fall intoprivate hands, but the rest is assumedto be increases in consumer surplus.

GRAY: We’ve sponsored some of thefollow-up studies to the original Mans-field work. And one study in particu-lar, by Romeo & Rappaport, com-pares the effects of innovations bysmall firms to innovations by largecompanies. The study finds that thegap between the social and privaterates of return is even larger forinnovations by smaller companies.And this is what you would expect: Asmaller company simply doesn’t havethe market power to capitalize on itsinnovation. Competitors typicallycome in and appropriate much of thegains.PETERSEN: It’s also interesting tonote that the private rates of return oninvestment in technology and R&Dtend to be much higher than theprivate rates of return on physicalinvestment. This supports my con-tention that companies face muchgreater difficulty in raising capital forR&D than for physical investment.And higher actual returns typicallyimply higher required rates of return.

Accounting for R&D

WETZEL: That last statement remindsme that I really have a bitch with theaccounting profession.CHEW: I don’t think you’re alone inthat, Bill.WETZEL: But I don’t know quitewhat to do about it. My problem iswith the GAAP requirement that saysthat corporations must expense theircorporate R&D immediately eventhough they can capitalize their in-vestment in tangible assets. For com-panies that invest heavily in R&D, thisreduces current earnings per shareand thus presumably also reducesstock prices and managerial bo-nuses—and I use the word “pre-sumably” by design.CHEW: I’m sure some of us willquestion your assumption. But don’tlet me stop you.

Unlike a public company,where a purely diversifyinginvestment adds no value,many private companiesavoid double taxation bymanaging individual portfoliodecisions at the corporatelevel.... Where I see problemswith the capital gains tax is itseffect of perpetuating holdingperiods. Because cashing outis so expensive, many privatecompanies I work with haveevolved into “mini-conglomerates” containinglots of what were once angelventures—many of whichhave foundered for want ofdiscipline or incentives.Diversification becomes soexpansive, so ingrained, thatit gives rise to significant“agency” problems.

—Pat Finegan—


WETZEL: Now, one possible solutionto this accounting deficiency wouldbe for companies to talk about theirR&D in, say, the cash flow section ofthe corporate annual report. I thinkthere’s room there for management tomake adjustments of their GAAP num-bers and to explain to investors whatsort of returns they expect to earn onthat R&D. The accounting professioneffectively assumes that R&D is goingto have no return. It’s all just moneydown the drain.FINEGAN: Most R&D-intensive cor-porations do mention and, indeed,they highlight their R&D spending. Infact, it’s a 10K requirement.CHEW: John Kensinger has recentlypublished a study of the stock marketreactions to corporate R&D announce-ments. John, could you tell us whatyou found?JOHN KENSINGER: John Martin, SuChan, and I recently published astudy in the Journal of FinancialEconomics that looked at the stockmarket’s responses to 95 corporateannouncements of increased R&Dexpenditures. We found that the av-erage market response was signifi-cantly positive, on average—and thiswas the case even for a smaller sampleof firms in which the announcementscame in the face of an earnings de-cline. We also found the market re-sponded very positively to announcedR&D increases by high-tech firms,but negatively to similar announce-ments by low-tech companies.

R&D Limited Partnerships

CHEW: So, the stock market, as short-sighted as its critics have made it outto be, does seem capable of anticipat-ing future benefits from R&D, even ifthe accounting conventions assumethey are zero. And, John, isn’t it alsofair to say that the market seems toattempt to discriminate betweenpromising and not-so-promising R&D?

KENSINGER: Yes, that’s what ourresearch suggests. But there’s alsobeen another trend in corporate R&Dthat may have been motivated, at leastin small part, by accounting consid-erations. Many public companies inthe ’80s began to fund some of theirR&D “off balance sheet” through avehicle called the R&D limited part-nership, or RDLP. Since the first RDLPwas formed in 1978, almost $4 billionhas been raised through roughly 250individual RDLPs. While it’s true thata change in the tax law in 1987 re-duced the attractiveness of some ofthese deals, close to a billion dollars inRDLPs has been raised since then.

To list some of the deals done thisyear, Gensia raised $26 million throughan RDLP this summer; Genetics Insti-tute did one for $37 million in July;Synergen did one for $50 million inFebruary; and PaineWebber Devel-opment raised a $50 million RDLPpool to fund corporate R&D projects.CHEW: Are the limited partners basi-cally the same institutional investorsthat might otherwise invest in ven-ture capital funds?KENSINGER: That’s right. These areall private placements with institu-tional investors.CHEW: And why would a companychoose that vehicle instead of fund-ing the project internally?KENSINGER: Well, as I said, therewere probably some tax and account-ing considerations at work here. But Ithink there’s something more funda-mental as well. During the corporaterestructuring movement of the ’80s,investors rewarded companies fortransactions that loosened manage-ment’s control over assets. Such trans-actions in effect gave the decision toreinvest corporate profits back to theinvestors who originally supplied thecapital. RDLPs, for example, are finite-lived entities that require that all prof-its from the venture be returned to theinvestors. By so doing, they eliminate

the temptation of corporate manage-ment to redirect corporate profitsinto unprofitable areas they want tosubsidize. The high debt financing inLBOs and HLTs, especially those in-volving restructurings of conglomer-ates, accomplished much the sameend. And investors have volunteeredto pay significantly higher prices forprojects where they have this kind ofcontrol. They’d rather finance spe-cific projects than entire companiesbecause companies last forever; oncethe capital’s gone in, it’s tough to getit out again. But if you invest in adiscrete project—say, a drug devel-opment project—then your capitalhas a well-defined repayment sched-ule and the project has a finite life,usually ten years or less.FINEGAN: But, in the case of a newdrug project, wouldn’t the parentcompany sponsoring the RDLP alsoserve as the distribution arm for theproduct? If so, it seems to me that atleast some of these RDLPs representa kind of strategic alliance. For ex-ample, a drug company whose spe-cial strengths are sales, distribution,and marketing may want to keep itsR&D outside the corporate structurein order to provide an entrepreneurialenvironment and incentives for thekey engineers that are going to takeit into the next century.KENSINGER: Yes, I agree that spe-cialization and incentives are impor-tant motives behind these RDLPs.And, to add to your point aboutstrategic alliances, PaineWebber De-velopment puts together pools ofR&D projects for institutional inves-tors; and since there is no corporategeneral partner to market the prod-ucts resulting from these projects,PaineWebber will often find or createmarketing partners for these technol-ogy ventures. As the general partner,PaineWebber will build alliancesbetween the technology and market-ing ventures.


FINEGAN: Right, but it seems to meyou could get the same specializationand incentive benefits by spinningoff the corporate R&D effort into apartially-owned subsidiary, and thengiving the key engineers significantownership of the subsidiary. For thisreason, I think one of the main mo-tives for RDLPs was to allow compa-nies to shift the sharing of incomeand losses for tax purposes over time.BATY: I think the real reason forRDLPs runs deeper than that. Actu-ally, there are a lot of benefits forinvestors, but one is the fact that theirreturns are a function not of profits,but revenues. They get their moneyback based on the top line, not thebottom line. They don’t care if theproduct is sold unprofitably, theycare only that it gets sold. And, unfor-tunately, revenues arrive a great dealmore reliably than profits, particu-larly in start-up and early-stage tech-nology deals.CHEW: John, I thought there werealso some major conflicts of interestbetween the sponsoring corporationthat served as general partner and thelimited partners supplying the capi-tal. Wasn’t it partly this problem thatgave rise to the demand for R&Dpools set up and managed by third-party investment bankers?KENSINGER: That’s right, but be-sides the third-party pools, there’sbeen another major change in thestructure of the deals that helps over-come this conflict-of-interest prob-lem. Most of the more recent deals bysingle corporate sponsors—includ-ing one that was done by Genentechin 1989 and all the deals done thispast year—now include substantialstock warrants in the sponsoring com-pany along with the standard part-nership units. Besides mitigating theconflict of interest, these warrantshave also effectively allowed compa-nies to place equity without goingthrough a public underwriting.

LOVEMAN: In some cases, RDLPs arealso being used as a vehicle to financejoint projects involving more than onecompany. And there’s also an interest-ing “managerial” twist to these jointventure RDLPs. This idea came to mewhen I was listening to Scott McNealyof Sun Microsystems talk about theirdeal with AT&T. He said that there isan important difference between un-dertaking a joint venture and a jointproject like an RDLP. The importantdiffence is that a project, as John said,has a contractually defined end. Thismeans that if you have two companieswith conflicting cultures and incen-tives, they have an incentive to get thething done—basically, just because

they don’t like having to deal witheach other. The contractual structureforces them to do the unpleasantrather than let the arrangement diethrough sheer neglect. In the case ofjoint ventures or strategic alliances,by contrast, there seems to be astrong feeling among a lot of corpo-rate CEOs that indefinite partner-ships between two companies likeIBM and Microsoft are almost certainto fail. It turns into an endless struggleuntil one side finally agrees to sell outits investment to the other.CHEW: So, is this all we can expectfrom our much vaunted joint ven-tures and strategic alliances?LOVEMAN: Well, that seems to be thecase when the companies are verydifferent.

A New Breed of VentureCapitalists

LOVEMAN: A number of the bigventure capital funds have recentlymade huge investments in old-linecompanies that are now virtuallybankrupt. These venture capitalfunds—which include one bank thatyou would all recognize immedi-ately—come in and buy up a control-ling interest. So some venture capital-ists have wandered far afield fromfunding path-breaking technologies.They’re in the business of financialrestructuring.BATY: You’re making a point I thinkis worth amplifying here. When thegeneral lament starts about how theflow of money into the venture capi-tal industry has fallen way off from itsformer peak, I would suggest you goback and look at the composition ofthat peak. Of the $4 billion that wentinto the industry in 1987, $2 billionreally went into just two funds thatwere doing financial restructuring.They don’t represent venture capital,they’re what Bill Bygrave and JeffTimmons call merchant capitalists.

During the corporaterestructuring movement ofthe ’80s, investors rewardedcompanies for transactionsthat loosened management’scontrol over assets. Suchtransactions in effect gave thedecision to reinvest corporateprofits back to the investorswho originally supplied thecapital. RDLPs, for example,are finite-lived projects thatrequire that all profits fromthe venture be returned to theinvestors. By so doing, theyeliminate the temptation ofcorporate management toredirect corporate profitsfrom profitable areas intoother areas they want tosubsidize. The heavy debt inLBOs and HLTs accomplishedmuch the same end.

—John Kensinger—


They’re opportunists operating di-versified equity pools whose aim is tostab whatever bleeds. They’re notstarting high-tech or innovative firms;they’re not funding the Federal Ex-presses or the Intels of the future.They’re white-gloves people whohave no interest in getting dirt undertheir fingernails.

So, if you ignore that $2 billion ofmerchant capital, the real peak forventure capital in ’87 was only around$2 billion. Now, I don’t think we’regoing to reach $2 billion this year; infact I think we’ll probably end up atabout a billion. But, while that’s notthat great, it’s also not the disasterthat is sometimes portrayed by peoplewho write for the Wall Street Journal.BYGRAVE: To evaluate the currentlevel of venture capital, you reallyhave to use a little historical perspec-tive. As recently as 1974, there wasonly about $20 or $30 million a yearin new money. On an inflation-ad-justed basis, I think we’re still on amuch higher level than we were in,say, 1968, which was the last peak ofthe venture capital cycle.BATY: Oh, easily.CHEW: So, if you remove these LBOsand financial restructurings from thetotals, then there is no trend, or justa slightly upward trend?BATY: No, the trend is definitelydown from the peak, or what I wouldcall the period of “excess,” of the mid-’80s. No question about that.

But, you see, that’s the mechanismby which the returns are going to startcoming back to some kind of histori-cal average level. And there are twoeffects at work here. First, the invest-ment decisions will become moreconservative and the ROIs at harvestare going to be higher. And second—and although this has largely escapedthe scrutiny of academia, I think it’sgoing to turn out to be important—there’s a tremendous secondary mar-ket developing in partnership inter-

ests. When a bank goes defunct andthey have on their balance sheet a$20 million investment in venturecapital partnerships, there are ven-ture capital funds set up to go bottomfishing and buy up those outfits atanywhere from 25% to 75% of theoriginal cost basis—that is, at verylow valuations. And that activity aloneis going to give a significant uplift tothe ultimate returns to the industry.So, even as we sit around and lamentand hang crepe, I think the returnsare on their way back up.

Now, the returns are almost cer-tainly not going to rise to the 40%levels that Bill was attributing to 1982-83—and I think that will turn out tohave been an anomalous era. What Ithink we will find is a return to some-thing more equivalent, say, to theaverage of the last 12 or 15 years.PETERSEN: Well, let me point outthat in the case of this bottom fishingin the secondary market, the increasein investor returns does not representan increase in the social return. It’sjust taking an asset off of one balancesheet and replacing it on another;one party’s loss is another party’sgain. And from a social point of view,it’s thus a zero-sum transaction.CHEW: But I think Gordon’s alsosuggesting that this kind of financialinvesting performs a social functionjust by helping to revive the market.Strengthening the secondary marketmay be what’s necessary to get theprimary market back on its feet.BATY: Yes, that secondary marketactivity will increase the propensityof some of the people who havepulled away from venture invest-ment to move back into it once theysee the returns coming back.

Illiquidity and High ExpectedReturns

BYGRAVE: Let me just say somethingabout returns. Given our present

knowledge that historical returns haverun on the order of 15% to 20%, thisshould help educate investors andhelp manage their expectations: 15-20% is really not at all bad for apension fund that invests in, say, 60different venture capital funds. Ex-cept for the last ten years, when theS&P has performed extraordinarilywell, I think a normal rate of return onthe S&P would run in the range of 7-10%. So, placed in this historicalperspective, 15-20% for venture capi-tal is probably quite acceptable.FINEGAN: But it seems to me youhave to adjust all these return calcu-lations for interest rates. Have youattempted any of these adjustments?BYGRAVE: I agree that we should.But, let’s say that the expected rate ofreturn on venture capital is 15%, andthat the expected rate on the S&P 500is half of that (as the actual returnfrequently turned out to be in theyears between 1946 and 1981). In thatcase, I would say that 15% is not a badreturn for pension fund managersabsolutely swamped with money flow-ing in every day—and terrified aboutwhere they’re going to invest it beforethe day is out. And I think once fundmanagers come to accept that 15-20%,not 30-40%, is the realistic range ofexpectations, they will actually findthat historical yield attractive.CHEW: Based on current long Treas-ury yields of about 8%, I would guessthat the expected return on the S&P500 would be at least around 14-16%today. If that’s true, then a 15-20%expected return on venture capitalseems like a pretty meager premiumabove the S&P 500 when you con-sider the illiquidity along with thelevel of risk.BATY: Well, one man’s illiquidity isanother man’s stability. The pensionfund manager has a number of prob-lems besides illiquidity. He needs theability to plan liquidity; and venturecapital can play a role in that plan-


ning. A whole portfolio of venturecapital partnerships would not be agreat pension fund. But one thatincludes a few funds makes all kindsof sense from a liquidity planningpoint of view.BYGRAVE: I believe the entire poolof U.S. pension fund money is about$3 trillion. And let’s say there is about$30 or $40 billion tied up today inventure capital. Now, if that amountcould come from pension funds, thenwe’d still only be talking about onepercent of all pension monies goinginto venture capital. So, when yousay you’re concerned about the illiq-uidity of venture capital, I think youought to keep in mind that pensionfunds can certainly afford to havesuch small amounts in a relativelynon-liquid form.CHEW: But the question I’m asking isabout the marginal effect of venturecapital investment on the risk andliquidity of a portfolio. Investors’ re-quired rates of return, at least as Iunderstand the theory, are supposedto be determined by the effects at themargin.FINEGAN: This may be another rea-son why the market for angel financ-ing seems to be going strong whileinstitutional venture capital financ-ing is down. I think it has less to dowith individual risk preferences andpeople’s willingness to put moneyon the line than with turnover expec-tations—with how frequently inves-tors expect to want to enter and exita security. As long as the time horizonbetween transaction costs is longerfor a so-called angel than for a pas-sive venture fund investor—as I thinkit inevitably will be—then the angelcan afford to pay a higher entry pricebecause the exit costs will be less; theexit costs will be lower not only forthat particular investor, but for allsubsequent investors.

To illustrate how illiquidity raisesexpected returns and lowers prices,

look at the current condition of thejunk bond market. I’ve been involvedin some recent work valuing a num-ber of junk bond portfolios ownedby bankrupt institutions. Because ofthe lack of liquidity in the currentenvironment, to sell a junk bondportfolio you essentially have to per-form an IPO. You essentially have tore-market the portfolio to the invest-ment community.

For a thinly traded junk bond, thecosts of such a re-offering often run ashigh as 400 to 500 basis points. And ifyou consider that the average turn-over of junk bonds in institutionalportfolios is still, even in today’s dis-tressed marketplace, about 18 months,

and if you assume we will have anilliquid market in most junk bondsfor at least another three or four moreyears, then you’re talking about tak-ing off 10 or 15% of the portfolio’svalue in transaction costs. This is thesheer cost of illiquidity.

So, I think the average expectedturnover is a critical pricing variable ina highly illiquid market that, like ven-ture capital, has high search costsassociated with valuing the assets.And given this kind of illiquidity pre-mium today, if you were a small pri-vate company seeking access to capi-tal, you would do everything withinyour power to resist the temptation touse the debt markets currently. Smallcompanies can’t afford to give up thatmuch money upfront. And, to a similardegree, I think the liquidity crunch isprobably troubling the institutionalventure capital markets. So, to theextent angels really do have longerhorizons, they can be expected tofund more start-up ventures than theinstitutional venture firms.BYGRAVE: Another potential prob-lem with venture capital investmentis that pension funds are forced toundergo quarterly performance evalu-ations. When we were surveyingpension funds and banks on theirpropensity to invest in venture capi-tal, one pension fund manager com-plained that he was being evaluatednot on a quarterly, but on a monthlybasis—just like the people on thetrading floor. Now, it’s obvious youcan’t judge venture capital monthly.Almost all the value is in the residual,which is just not liquid.FROOT: I agree with Bill that this kindof periodic evaluation process couldcertainly skew investment decisionsaway from highly illiquid investments.And this is not a problem of short-sighted investors or market myopia; itreally reflects a kind of principal/agent problem between the pensionbeneficiaries and the pension fund

The practices andconventions of our venturemarkets may contain at leastpartial solutions to theproblems faced by our largestcompanies in raising capital—especially the credibility gapwith investors that academicshave called “informationalasymmetry,” but also the so-called “agency cost” problem,the separation of ownershipfrom control that reduces thevalue of many of our largestcompanies. For example,large public companies couldprobably learn much fromventure capitalists about howto fund and structure theirown R&D and other growthinvestments.

—Don Chew—


manager. If you’re a pension fundmanager managing money for otherswho don’t share your confidence inyour own ability, it’s easier for you todemonstrate your confidence by vol-unteering to subject yourself to areview 12 times a year instead of onlyonce or twice. And if you knowyou’re going to be reviewed 12 timesa year, then you’re going to want toconcentrate your holdings in rela-tively liquid investments with valuesthat can be readily confirmed.

Increasing Liquidity

BATY: You know, if this group ofaugust thinkers had a valuable con-tribution to make today, it would beto come up with some workableproposals for adding liquidity to theventure capital pool. Illiquidity is oneof the main reasons why a lot ofinvestors such as small pension fundsand small insurers stay away from it.CHEW: Do you mean an exit route?BATY: Yes, an exit route, or possiblysome other kind of liquidity mecha-nism—something akin to what Salo-mon did in the early ’80s to securitizehouse mortgages. If there were a waythat could be proposed by somebodya lot smarter than I to securitize abundle of venture capital partner-ships, that would eliminate one ofthe main reasons why this enormousrisk premium is expected. As youpoint out, it’s not a risk premium somuch as it’s a liquidity premium.CHEW: Well, how efficient is thismarket for rescuing distressed ven-ture funds that you were talking about?BATY: It’s not efficient at all. It’s asinefficient as anything could be.WETZEL: I have an idea that’s beenstewing around in my head that I’venever really explored thoroughly. Themanagers of pension funds are as-sumed to be skilled at managingportfolios of listed securities and inevaluating the track record of estab-

lished companies. And they are alsopermitted by ERISA law to investsome fraction of their portfolio in theventure capital business.

Why wouldn’t it make some senseto amend the ERISA law to permitpension fund managers to put a frac-tion of their assets into establishedprivate companies, where they reallydo have the technical ability to evalu-ate the merits of the investment?Pension funds could thereby providean exit mechanism for seasoned com-panies that don’t want to go public orbe acquired. This would add an ele-ment of liquidity to the system—onethat would also end up allowingmoney to be recycled back into theearly-stage developments that Gor-don manages. It strikes me that there’sa real opportunity here to add anelement of liquidity; and this liquid-ity would permit professionally-man-aged venture money to circulate muchmore rapidly than it currently canbecause of the limitations of theacquisition and the IPO market.BATY: It’s an interesting thought. Itcertainly addresses one of the princi-pal problems of the venture capitalprocess. It’s real easy getting intodeals, but it’s very hard to get out ofthem. And it’s particularly hard to getout of deals in the intervals when theNASDAQ is in the toilet. It’s particu-larly difficult to get out during arecession when the companies thatyou would normally sell your dealsto are themselves struggling. I thinkany alternate mechanism that wouldprovide liquidity to the investors inventure capital pools is going to do alot to recycle the pool itself.BYGRAVE: Gordon, do you mean itwill help us unload the losers?WETZEL: Well, presumably the pen-sion fund managers will be able toseparate the lemons from the winnersin these more established companies.That’s why I think there’s some reasonto believe this would work.

PETTY: The American Stock Exchangerecently announced that it’s going tobegin to list emerging companies.Will this have any significant impactin this situation?BATY: Could be. Any time peoplereduce the standards for listing, weall cheer.

More on Angels

LOVEMAN: Let me just add one thingthere. As a consequence of spendinga lot of time in Warsaw recently, I’vegotten into a number of discussionswith venture capitalists—the kind ofpeople who these days are gettinginvitations to Poland all the time. Andfrom these talks I’ve reached theconclusion—and this is admittedly avery unscientific discovery process—that the art of venture capital is notrunning numbers or surveying theindustry (although venture capital-ists do employ lots of Ken’s and myHarvard MBA students to do thesethings). The real art of venture capitalseems to be in deciding whether theguy or the gal who runs the companyis the right person to back. And if theanswer is yes, then it’s largely amatter of building the right incentivestructure for that person.

Now, when I heard this concept ofangels—one which I hadn’t heardbefore today—that got me thinkingthat these wealthy self-made entre-preneurs are probably the peoplewho are best qualified to make thesekinds of judgments about who toback. They may well understand theworld in which they’ve gained theirown wealth far better than the aver-age venture capitalist. Bill Gates, forexample, could personally finance apretty big venture capital fund if hewanted to; he meets the minimumcapital requirements quite comforta-bly. The alternative, though, is thathe becomes an angel and does it onhis own. And if he does it on his own,


it’s presumably because he believeshe has better information about theindividuals who run these opera-tions than the venture fund manag-ers.BYGRAVE: Gates does fund someventures, by the way. For example,he and a number of other wealthyindividuals funded ICOS, a bio-phar-maceutical start-up. He invested $5million in June 1990. His investmentwas worth almost $14 million oneyear later when ICOS went public.WETZEL: So do Ross Perot and SteveJobs.BYGRAVE: And so did Robert Noyceof Intel. And the d’Arbeloff brothersused to do the same thing in theBoston area. One reason these peopleare encouraged to participate is thekind of certification effect their par-ticipation has. If Noyce is willing toput his own money into it, this putsa seal of approval on the deal.CHEW: And they can then raise capi-tal from others on the strength of thatparticipation?WETZEL: That’s right. It’s a form ofsignalling.

Changes in Deal Structure

PETTY: Gordon, given the decliningrates of return in venture capital, havethere been any pronounced changesin the structure of the contracts be-tween the general partners runningfunds such as yourself and your lim-ited partners? And a related question:Have there been changes in the con-tracts between you and the entrepre-neurs that you provide funding for?BATY: Well, I guess the most obviouschange since the peak period of1987-88 is probably the fact that somany of the people who used to fundearly stage and start-up ventures don’tdo it any more. That means those of uswho still do it—and we’re one of ahandful of companies left—have re-ally almost no competition in funding

early stage deals. So there’s no re-straint on our avarice other than ourown self-interest in making sure weleave the entrepreneur with enoughequity to motivate him to get him outof bed in the morning.PETERSEN: So, you’re leaving theentrepreneur with a Malthusian rateof return?BATY: Thank you for giving me alabel.CHEW: Gordon, how do you sort outthe good deals from the bad? Do youuse the contracting or negotiatingprocess to in some sense flush out theentrepreneur you’re considering fund-ing? Do you offer him a menu of dealsand then ask him to choose one?BATY: Yes, we do in fact.CHEW: Can you tell us a little bitabout that?BATY: Well, the price is only onedimension of a really complex, multi-dimensional negotiation. You lookat one of these investment agree-ments for a preferred stock place-ment, for example, and there must be15 variables. There’s a question ofwhether it’s participating preferred orstraight preferred, and there’s a ques-tion of the conversion rights andwhen they first come into effect. It’ssometimes a question of whetherthere’s a dividend due, under whatcircumstances it’s payable, andwhether it accumulates or not.

So, the poor guy across the tablehas to have a Ph.D. in finance tofigure out where his self-interest lies.If you push down on one variable,another one invariably pops up. It’slike pushing the bubble around in anair mattress.

But, at the end of the day, the dealsare tougher now than they were twoor three years ago. That’s the princi-pal distinction. We expect our entre-preneurs to do more with fewer dol-lars. I think that, as an industry, weventure capital people are inclined toundercapitalize things. And there’s a

strange conspiracy at work betweenthe entrepreneurs and the investorsthat almost guarantees things arealways undercapitalized and starv-ing: We don’t want to put moremoney at risk than we have to, andthe entrepreneur doesn’t want to putmore equity on the table than he hasto. So everyone kind of joins handsand jumps off the cliff without themoney that we should have—and weall pretend that we believe the busi-ness plan.CHEW: But, Gordon, that partlymakes sense, doesn’t it? The entre-preneur gets a review, in effect, whenhe runs out of cash. And it seems tome the earlier he’s willing to submitto that review, the more confidencehe’s expressing in the deal. And thisin turn gives you more flexibility as towhether or not you want to fundfuture development. It gives you avaluable option.

And the more willing the entrepre-neur is to undercapitalize himself, asI said earlier, the stronger signal he’ssending to you about his own level ofconfidence in his plan. So, in thissense, it may make a lot of sense toundercapitalize entrepreneurs at thestart; it may be an effective signallingmechanism.BATY: Well, you’ve just sort of epito-mized the Yankee type of venturecapital deal as opposed to the Califor-nia deal. In fact, if we could, wewould have a closing every week.That’s the way we Yankees tend tothink. And it may in fact turn out tobe a bit penny-wise and pound-foolish, given the enormous successof the California venture capital com-munity relative to the depressed con-dition of the Northeast in recent years.CHEW: Is that a well-established view,that the California style works better?BATY: Well, if you look at the enor-mous growth of Silicon Valley inrecent years, it’s easier to accept thisargument than to disprove it.


BYGRAVE: That would be a goodarea to research, to see if in fact ratesof return have been systematicallyhigher in the California ventures thanin the Northeast. But there may besome contaminating factors at work.For example, we’ve got a huge reces-sion in Massachusetts. We’re in thethird year of what is at least a five-yearrecession, in my opinion. We havenot had a billion-dollar start-up sincePrime Computer in 1972. Since then,California’s had Apple, Sun Microsys-tems, Tandem, Seagate, and Conner.So, it may just be that Californiahappens to be geographically situ-ated at the right point. That’s wherethe chip manufacturers are, and sinceeverything’s based on the chip thesedays, location may be the criticalfactor in the California successes.

But, maybe you’re right, Gordon.Maybe it is a matter of too muchparsimony among our venture capi-talists in Massachusetts.

Higher Investment Stakes andStrategic Alliances

STEVE MAGEE: Well, what’s happen-ing to the rate of innovation in the U.S.today? You’ve got to keep in mind thatwe’re always going to pass up somegood deals. There’s type one and typetwo errors, and we’re going take somedogs and we’re going to let some greatones get away.BYGRAVE: Well, there was a big fussamong the federal policymakers thata lot of promising high-tech people,the next Ken Olsen and the next BillGates, weren’t getting funded. But Idon’t think there was really any evi-dence for that.

Gordon, do you have a strongsense that today there are really de-serving entrepreneurs and deservingtechnologies that aren’t being com-mercialized, either not at all or not asfast as they could be through lack ofventure capital?

BATY: I don’t have any real sense ofthat, Bill. And it’s a lack of evidence,not evidence to the contrary. I justhave no way of knowing. We have aconstant parade of people throughour office. Every morning I’ve got afoot of business plans on my desk.And the question I ask myself everyday is, Which one is going to get readthat day? Because one a day is aboutall I can handle.

But, even with the tight conditionstoday, I suspect that there are proba-bly more or less the same number ofunderfunded geniuses going with-out today as there were a decade ago.BYGRAVE: Al Bruno and TyzoonTyebjee did some work for the Na-

tional Science Foundation that at-tempted to identify the opportunitiesthat got away—the ones that nevergot funded. The premise underlyingthis work was that deserving entre-preneurs weren’t getting funded andthat, somewhat like the unemployed,they got discouraged and droppedout of the entrepreneurial pool. Buttheir work didn’t come to that con-clusion. It suggested instead that en-trepreneurs don’t disappear, but ratherthey sort of hover around, and thencome back and try again—and some-times they succeed in getting venturecapital.GRAY: We haven’t really addressedthe size issue in this discussion. We’vebeen talking about the very bottomend of the market, with the angels,and then we’ve moved up a little bitto relatively small corporate projects.We also mentioned that back in thelate ’70s there were a lot of technolo-gies ripe for the picking. A lot of thosetechnologies have matured. And thereality today is that, where we onceneeded relatively small investmentsto develop, we now need large in-vestments to play in the game.

I’m thinking in particular of a caselike the relationship between Com-paq and Conner Peripherals. Connerhad an innovation that had to bemarketed quickly if they were goingto grab the market. If they went inslowly and fought to raise the capital,their ideas would have been appro-priated before they could have cap-tured a market share big enough towarrant their investment. So Compaqcame to them and said, “Not only willwe buy the product, but here’s $100million to help make it.”

That has raised the investment antein the game tremendously, and itstrikes me that’s what’s happened toa lot of this market. We’re now talk-ing about biotechnology and aboutcomputer-related innovations. Theseare areas where the price of entry is

John Kensinger and I havebeen studying cases where acorporation makes a minorityequity investment in a keysupplier or customer. In thepast ten years, for example,IBM has made 13 suchinvestments and HewlettPackard has made six. Most ofthese represent sums far inexcess of the typical venturecapital investment. This isevidence that large integratedcorporations are increasinglyserving as a source of riskcapital. Further, as the size ofthe investments required toenter high-tech industriesescalates, I think we will seenew start-ups becomeincreasingly dependent onfinancing sources othertraditional venture capital.

—John Martin—


much higher than the venture capitalmarket was ever equipped to dealwith. And there’s a demand for speedas well as capital: If you’re going tocapture the gain from your invest-ment, the competition is such thatyou have to be able to move quickly,and move quickly with large dollars.FINEGAN: Do you expect to see thisreflected in the number of strategicalliances forged each year in high-tech land? They seem to be growingat a rapid rate.GRAY: I think they’re growing tre-mendously. In fact, I suspect thatsimply because of the increase in thesize of the investments required, U.S.corporations are now taking the placeof venture capital firms in a greatmany instances.JOHN MARTIN: I think you’re right,Tom. John Kensinger and I have beenstudying cases where a corporationmakes a minority equity investment ina key supplier or customer. In the pastten years, for example, IBM has made13 such investments and HewlettPackard has made six. I don’t knowthe dollar amounts involved in mostof these cases, but I can tell you thatmost represent sums far in excess ofthe typical venture capital investment.For example, Ford, Kubota, andTenneco together invested some $250million in Cummins Engine. Now, it’strue that Cummins and other recipi-ents of this kind of financing arecertainly not the typical start-ups servedby venture capital firms; but I thinkthis is evidence nonetheless that largeintegrated corporations are increas-ingly serving as an important sourceof risk capital.

Let me conclude with the exampleof Hal Business Systems. Hal is a newstart-up enterprise that has offices inAustin and is a member of the AustinTechnology Incubator. The companywas founded by a former IBM em-ployee, Andrew Heller, with the fi-nancial backing of Fujitsu Corpora-

tion. The interesting thing about thisstart-up is the magnitude of the start-up financing. Hal obtained a commit-ment for over $40 million from Fujitsubefore the firm was to have a sellableproduct.

So, I think that corporations maywell be playing a venture capital rolein these high-dollar start-ups. Fur-ther, as the size of the investmentsrequired to enter high tech industriesescalates, I think we will see newstart-ups become increasingly moredependent on financing sources otherthan traditional venture capital.BYGRAVE: I don’t believe that start-ups are turning to corporations sim-ply because of the amount of moneythey need. Rather, it’s because corpo-rations are willing to offer the entre-preneur cheap capital, relativelyspeaking, in the hope of receivingbenefits from a strategic alliance witha dynamic young company. That iswhy some “high-profile” entrepre-neurs such as Finis Conner, thefounder of Conner Peripherals, pre-fer to get their funding from corpora-tions instead of venture capital firms.

Look, for instance, at how SteveJobs financed NeXT. He raised about$20 million from Ross Perot for about16% of NeXT’s equity, and then, acouple of years later, raised another$100 million from Canon for another16%. Remarkably, even after Canon’sinvestment, Jobs still owned morethan 50% of NeXT, with a paper worthof $300 million plus. And NeXT wasthen a company that had not shippedproduct. If Jobs had instead financedNeXT with venture capital, he wouldnot have owned even 10% at thatpoint—maybe much less. Canon wasmore generous than a venture capi-tal syndicate would have been withits financing terms because it wasentering into a strategic partnershipwith NeXT. Besides getting a shareof NeXT’s equity, it also got market-ing rights to NeXT’s products.

Now when it comes to harvestingmechanisms, it may be that corpora-tions are playing an increasing role.We know that, since around 1985,proportionately more venture-capi-tal-backed companies have been ac-quired by corporations than havegone public, which is a significantbreak with the past. Certainly, therehave been some spectacular acquisi-tions of venture-capital-backed bio-tech companies by multinationalpharmaceutical corporations. In someof those cases, the amount of moneywas probably more than could havebeen raised through a public offer-ing, let alone a private venture capitalplacement. For instance, the Swisspharmaceutical giant, Roche Hold-ings, bought 60% of Genentech for$2.1 billion. I think it worked out tobe a P/E of about 80. But we are nottalking about a start-up here. Genen-tech is a 15-year-old public companywith revenues of about $500 million.Again, as with Canon’s investment inNeXT, those kind of valuations arejustified only by the investing com-pany’s perception of substantial stra-tegic synergies from the deal.

Let me also mention that I knowsomeone who is starting a venturecapital fund, and right in his prospec-tus it says that the harvest mechanismfor his portfolio companies will beselling them to strategic partners. Infact, it’s partly because of the unrelia-bility of the market for public offer-ings that strategic partnerships havebecome so popular in the biotechindustry.

The Next Wave

BYGRAVE: I think we’re all waitingfor another technology wave. There’sonly so many technologies that comealong. We had a miraculous wave oftechnologies in the ’70s and I don’tsee anything as spectacular as thepersonal computer on the horizon.


The PC business went from zero to a$100 billion business worldwide in15 years. The biotech sector, by con-trast, has got only four billion dollarsof total revenue right now. Commu-nications also have a lot of promise.But I really don’t see any miraculouswave of electronics technology that’sgoing to generate a $100 billion mar-ket in ten years.

Cold fusion could have been some-thing very big. It promised an abun-dant—indeed, a limitless—source ofcheap electricity. Unfortunately, itturned out to be a mirage. If it hadbeen real, it would have solved theproblem of generating electricity,which is one half of the electricityequation. But we may now be closeto a solution to the other half of thatequation, which is minimizing elec-tricity losses. High-temperature su-perconductors show great promisefor transmitting electricity with littleor no losses. They have the potentialto trigger a revolution bigger thananything since electricity was firstused commercially a century of soago. But we’re not there yet.

So development in the biotechsector and these other areas isn’tgoing to replace the jobs being lost inthe PC market anytime soon. Maybethey will eventually, but it will take awhile. According to one estimate,biotech won’t be a $50 billion marketfor another decade or so.BATY: I’m not smart enough to saywhat’s going to be the key technol-ogy in a decade. When I was workingfor Burroughs back in 1979, I boughtone of those crafty little Apple IIcomputers because they ran a spread-sheet. In those days, a computer tome was something that would havefilled this room—that was a com-puter! So I wouldn’t have investedany money in Apple, or Kaypro, orany of those people.BYGRAVE: That’s right. The technol-ogy field is just full of gurus who have

made wrong forecasts. In 1943, TomWatson predicted that the total worldmarket would be ten very large com-puters. Ken Olsen said he couldn’timagine why anyone would ever wanta computer at home—and that, by theway, was after committing to make theRainbow personal computer.

A Network for Angels

GRAY: When we did our surveys ofthe angel market in ’87-’88, one of thequestions we asked was: If therewere additional ventures availablewith characteristics similar to thoseventures you’ve already invested in,would you have been willing to make

additional investments? From the re-sponses, we estimated there was over50% excess capital available at thatpoint in the angel market. And I’veargued ever since then that we havean opportunity-constrained situationhere. Capital is clearly not the scarceresource.CHEW: But, again, there may be veryhigh search or information costs inlinking angels to entrepreneurs. Asyou yourself suggested, Bill, angelsare likely to fund only people theyknow in businesses they know. Andthat’s a very real constraint.FROOT: Well, from Gordon’s story, italso sounds like human capital maybe constrained as well. There may bea real shortage of people like Gordonwith the experience and knowhowto read these business plans and turnthem into productive businesses.BATY: I can manage about ten com-panies in my portfolio at any giventime, but I can’t manage twenty. So ifyou handed me twice as much moneyas I’m currently managing, I couldeither decline it, or I could go out andhire some bright MBA to run part ofthe portfolio. But the average qualityof the management is going to godown.BYGRAVE: Maybe it will go up, Gor-don. Who knows?BATY: Right, maybe it will go up—orsideways. I withdraw the foregoing.BYGRAVE: When I started my firstcompany back in 1970 with venturecapital, it was a tremendously secre-tive industry. There were no directo-ries then and you didn’t have anyidea whom to contact or how to goabout doing it. Today, there’s almostan overabundance of people likemyself and Bill Wetzel who will freelysupply information about the ven-ture capital industry—about how tonegotiate with Gordon, and how toraise capital. And that must surelyhave helped to increase the effi-ciency of the marketplace.

Since around 1985,proportionately moreventure-capital-backedcompanies have beenacquired by corporations thanhave gone public, which is asignificant break with thepast. In some of those cases,the amount of money wasprobably more than couldhave been raised through apublic offering, let alone aprivate venture capitalplacement. For instance, theSwiss pharmaceutical giant,Roche Holdings, bought 60%of Genentech for $2.1 billion.Those kind of valuations arejustified only by the investingcompany’s perception ofsubstantial strategic synergiesfrom the deal.

—Bill Bygrave—


WETZEL: But there has not been agreat deal of this kind of activity inthe angel marketplace.BYGRAVE: No, you’re right. You’revirtually alone, Bill, in providing ameans for people to find angels.Sometimes would-be entrepreneurscome to see me, and I tell them, “Oh,that’s not a venture capital deal, that’san angel deal.” And they say, “What’san angel? And you then explain tothem that an angel is this thing withfeathers and wings.

Then they say, “Well, do you knowof any?” And of course you do, butyou don’t want to risk a friendship. Soyou instead tell them to call Bill Wetzelbecause Bill’s got this venture capitalnetwork, which has just been movedto MIT. And before Bill tells you moreabout it, let me say just that I think theformation of this network is a verypositive step. It should really improvethe efficiency with which we connectpromising entrepreneurs with otherentrepreneurs with capital.WETZEL: Well, this angel network isstill an experimental undertaking. Itwas started at the University of NewHampshire, where I teach. And it’sjust been moved down to MIT as partof the MIT Enterprise Forum. I hate touse the analogy, but I can capture thesense of it fairly easily by calling it a“dating bureau.” It gives an indi-vidual investor who will never belisted in the Pratt’s Guide to VentureCapital Sources (they keep very lowprofiles for obvious reasons) a chanceto remain anonymous, but still havean opportunity to look at a partiallyscreened deal flow.

Our entrepreneur database is alsoconfidential. It requires an entrepre-neur to submit a two-page executivesummary of the business plan (thatappears in our database without thename of the entrepreneur or anyproprietory information). If there seemsto be a match between theentrepreneur’s proposal and an an-

gel’s expressed area of interest, thosepieces of data change hands. And ifthere’s further interest, the two areintroduced to one other, and it goeson from there. We have not yet proventhat this network is going to be asignificant factor in the angel market-place, but we have high hopes for it.MARTIN: Bill, I would like to addbriefly that we have started a similardating service in Austin. It is calledthe Texas Capital Network and it is anon-profit corporation that operatesas a member firm in the Austin Tech-nology Incubator. Although the Net-work is less than two years old, it hasalready succeeded in matching up anumber of small firms with investors.

PART II: EASTERN EUROPE

PETTY: Well, let’s turn now to therole of venture capitalists in fundinggrowth in Eastern Europe. Is there arole for institutional venture capital?If not, then where is the new moneygoing to come from?

An Alliance between PublicCapital and Private Management

BYGRAVE: The largest venture capi-tal fund in the world is in fact anEnglish institution called “3i.” Quiteinterestingly, it was started in 1945 bya socialist government in those darkdays when the socialists were busilynationalizing all of the strategic in-dustries—coal, steel, railroads, trans-portation. And yet, in spite of theseunlikely beginnings, that companyhas an extraordinary record. It hasinvested in some 10,000 companies.And, as of year-end 1991, the com-pany had over $5 billion under man-agement that was invested in about4,000 active companies in its variousportfolios. It invests as little as$100,000, and as much as $10 million,in any single venture. It also providesfunding for companies in all stages ofdevelopment. In 1989, for example, itdid over 200 start-ups, and about 800deals in total. Its return on equity inthe late 1980s was about 25% (al-though, unlike most venture capitalfirms, it has considerable debt as wellas equity on the right-hand side of itsbalance sheet).

What is especially interesting tome is the difference between howthis British venture fund operatesand the way most of our funds oper-ate in the U.S. In 1989, for example,3i paid out only $20 million in divi-dends while reporting $464 millionin capital gains. The fund manager’spolicy is to plow most of their currentreturns back into new investment;and the company’s been doing that

Stewart Myers and NicholasMajluf demonstrated thatinformation asymmetry leadsto underinvestment by“outsiders.” Nowhere is thisproblem more acute than inthe case of risk capital,particularly when it comes tobank financing. Whileventure capitalists canstructure deals to reduce theproblem significantly, U.S.banks are prevented fromdoing so by regulation. InWestern Europe, for example,where banks have far greaterfreedom in contracting thanin the U.S., they haveprovided at least 40 percent ofventure funding, as comparedto only 5 percent in the U.S.(mostly through SBICs, whichare themselves a dyingbreed).

—Bill Petty—


ever since its beginnings. U.S. ven-ture funds, by contrast, operate verymuch on a project-by-project basis,returning most of their profits to thelimited partners as they are earned.

Now, let me also say that althoughthe initial capital for 3i came from theBank of England together with thefive major English banks, the funditself is run completely privately, withno outside interference from govern-ment. And it seems to me that thiskind of alliance between public fund-ing and private management mightbe applied to Eastern Europe. Thismight provide a superior alternativeto the “impatient” model of venturecapital in the U.S. It’s true that mostU.S. funds will give ventures as longas ten years to develop, but that maynot be long enough, especially in acase like Eastern Europe.BATY: That’s right. You don’t want alot of limited partners who are sittingaround looking at quarterly IRRs.BYGRAVE: Exactly. And so the im-portant thing here, I think, is to getthe central banks involved. At thesame time you want to give theinvestors strong incentives to keepthe money in the venture capitalpartnership as long as possible. So, ifit were European banks that wereinvolved, for example, you mightwant to offer some special tax bene-fits for keeping the money invested.

3i, incidentally, has also clonedtheir model in India, with Grindley’sBank, and in Australia with Westpak.And, to my knowledge, the fund withWestpak is one of the only two viableventure capital funds remaining inAustralia. The other Australian fundswere started mainly in Victoria usinga lot of government subsidies andinitiatives. And the outcome has beenan enormous waste of capital in ter-rible deals that have been ruined bythe combination of inexperiencedventure capitalists and too muchgovernment interference. Almost all

the Australian venture capital fundshave failed miserably. But it seems tome that some modification of the 3imodel that unites public money withprivate management might have ashot at working in Eastern Europe.GRAY: The World Bank has funded anumber of small, venture-type groupsin Eastern European countries, whichis a departure from their typical roleof funding large infrastructure proj-ects. But, as far as I know, they havelost every penny they’ve ever put intoEastern Europe.BYGRAVE: In Massachusetts, we’vegot a similar fund, Mass Capital Re-sources, that attempts in a small wayto do what 3i has done in Britain. Iserved on the investment committeefor a while. It was started at theinitiative of Dukakis back in the late’70s, but all the money was put up byMassachusetts insurance companiesand pension funds. The insurancecompanies hired the people to runthe fund, so it was run entirely by theprivate sector. And that fund hasbeen quite successful in terms of thedividends it’s paid to its investors andthe number of ventures it’s financed.

But there was another fund startedat state initiative, Mass Technology,which is staffed by people I woulddescribe as “quasi-government ap-pointees.” And that fund’s not beennearly as successful. It’s arguably beensuccessful in the sense that it’s fundedlots of technologies without losingvery much money. But the truth of thematter is that it couldn’t pay back itsinitial capital to the state when thestate wanted it back last year to helpcut the state’s deficit. The fund manag-ers told the state, “Well, if you wantthe money back, then we will have toshut down.” Mass Capital, by contrast,could easily pay back its investment ifit chose to do so, and then raise newmoney in the private sector.

So, my point is that you probablyneed some government initiative and

funding to get large venture projectsoff the ground. But once you’ve donethat, then you’ve got to have the fundrun by the private sector with nogovernment interference whatsoever.GRAY: There are a number of stateventure capital funds that are run likeyour successful Mass Capital fund—that is, they combine governmentmoney with private management. Wedon’t yet know whether they areperforming well. The definitive stud-ies haven’t been done. But my feel-ing is that, if the states have enoughpatience to leave the funds there,they will eventually be profitable.

The Irrelevance of VentureCapital to Eastern Europe

LOVEMAN: I don’t want to bury thisdiscussion, but I would argue that theventure capital industry is almostentirely irrelevant to the current pre-dicament of Eastern Europe. Thinkabout Gordon sitting in his officewith 20 business plans on his desk.Now, although many of these plansare probably moonshine, at leastthey’re written in English and Gor-don can understand how the num-bers were calculated and so on.

In Poland, however, consider thatthe Prime Minister Bielecki—who isalso the country’s most famous man-agement consultant—will be the firstto admit that, if you asked for thefinancial statements of a particularcompany, you would get a documentthat would be almost incomprehen-sible. He would also warn you that,if you talked to the top managementof such companies, you would likelybe dealing with people who haverisen to prominence largely on thebasis of their capacity to misleadanyone who wants to know anythingabout what they do. And because theInformation Age has not arrived inPoland, the capacity of bureaucratsto mislead is enormous.


For example, when the World Bankdid a survey of Polish industry, theylooked at the tax registries to deter-mine what people are in what indus-try. And what they found, quite sim-ply, is that most people lie about whatindustry they’re in. In fact, in a studythey’ve done recently, they found thatonly about 25% of the addresses listedin the tax registry physically existanywhere in Poland. So, there aresome really basic problems that existin trying to find anyone that youwould want to do business with.

Now, this is not to say that therearen’t remarkable opportunities inPoland. We run across entrepreneursthere all the time who are able toexploit these niches in the marketthat have been created by 40 years ofgross mismanagement. There arepeople who, after the liberalization,imported bananas because you couldnever get a perishable good to mar-ket under the old system.CHEW: Are these natives or foreign-ers you’re talking about?LOVEMAN: This guy was a native,and his incredible insight was thatyou could book bananas on Lufthansaand get them to market before theyspoiled. And the guy’s made a for-tune. There are lots of these kinds ofvery basic opportunities.

For outsiders, however, the prob-lem is that such opportunities comeand go in an instant. Competition setsin very quickly. But when you startlooking for business opportunitiesthat are sustainable, then you reallyrun into complications. And, as aconsequence, the Poles have hadgreat difficulty in raising capital fornew investment.

The first people the Poles lookedto for capital were the Polonia, peopleof Polish origin living in the UnitedStates. The most famous one was aMrs. Johnson (née Piasecka), heir tothe Johnson & Johnson fortune, whoexpressed interest in buying the Lenin

shipyards. She almost promised tobuy the company before she both-ered to find out what the assets mightbe worth and whether the workerswould be willing to give up their rightto strike. That deal fell through.

So, what you need, at a minimum,are people who have remarkablemotivation and the resources to slug itout in an environment where thingsare changing just constantly. Propertyrights, in many instances, are poorlydefined. There is no bankruptcy lawin Poland. It’s completely unclear whatit means to go bankrupt. There’s noincentive for banks to push creditorsinto bankruptcy so that they can re-cover collateralized assets.

WETZEL: To go back to your originalpoint, Gary, what about the biggerventures? Are there many of thesegoing on?LOVEMAN: There have not been alarge number of big ventures in Po-land. I know of one venture capitalistfrom a very well-known fund whohas made about 20 investments inCzechoslovakia. And he’s alreadydevoted about two and a half years tothis effort. But let me also point thatthese investments don’t take a greatdeal of money since relative pricesare very low in these environments.And, in the case I just mentioned, themoney is coming from the samesources that the fund is using to fundits more traditional investments inthe U.S. and in Western Europe.GRAY: Are these forms of what youmight call bootstrap financing?LOVEMAN: Well, in his case, it’s bigpension fund money, just some smallportion of which is beginning to findits way into these places.

But, again, the Poles have beenvery frustrated by their inability toraise money from just about any-where. The Minister of Privatization isjust this month beginning a dog-and-pony show all around the UnitedStates, trying to appeal to Polish Ameri-cans in particular. But such efforts, asI mentioned, are running up againstthese kinds of information problems,the ambiguity surrounding propertyrights and legal structures, and thecomplete ineffectiveness of the bank-ing institutions in Poland. All of thesethings are fundamental to foreign in-vestment of any size.GRAY: Yes, but my impression is thatthere’s an American on every streetcorner saying, “You’ve got to privat-ize, you’ve got to establish propertyrights, you’ve got to put a bankruptcylaw into place.” So, it’s clear whatneeds to be done. My question is,What’s holding up the process on thePolish end?

Here is the situation thePolish government is facedwith. There are currentlyseven or eight thousand stateenterprises in Poland not yetprivatized. The value of thesecompanies is falling virtuallyevery day, because theworkers are literally walkingoff with the assets. The bestworkers and managers aregoing to the private sector,and the state budget is anunmitigated disaster. So, notonly do they have to actquickly, but they have to do iten masse. They have got tofind a way to transferownership of a very largenumber of companies to theprivate sector in a singletransaction, or through asingle legislative act.

—Gary Loveman—


LOVEMAN: Well, it’s mainly political.The first fully free parliamentary elec-tion in Poland will be held the 27th ofthis month. Sixty-five parties haveregistered candidates for that elec-tion, and until that process is com-plete, no one is going to really doanything. The privatization issueshave so many constituencies aroundthem that it’s difficult to get anymovement forward.

But let me make one other pointhere. As Bielecki would be the firstone to admit, the truly scarce re-source in Poland is competent man-agers. I’ve been contacted by a num-ber of American companies who wantto do something in Poland. They willask me, “Can’t you simply find me aPolish manager who can prepare abudget, hire some other people, anddo some fairly basic things? We’ll doeverything else. We’ll give themmoney, we’ll buy the land if we can doit.” So I’ve sensed that a good numberof these deals are not happening inlarge part because you can’t find well-trained Polish managers.

Vertical Integration GoneHaywire

GRAY: In Moscow McDonald’s put ina very large operation. But beforethey did that, they spent about fiveyears building an infrastructure thatwould support their market. Theywent out and actually taught thefarmers what they meant by a head oflettuce. They literally took every as-pect of their production function andsaid, “We’ve got to vertically inte-grate this all the way up and down.And until we get that infrastructurebuilt, we aren’t going to put a ham-burger patty out on the stand.”CHEW: What’s the expected rate ofreturn on that investment?GRAY: Well, I don’t know. I thinkMcDonald’s makes good money inthis country doing the same thing.

CHEW: Yes, but they presumably don’thave to build infrastructure here.FROOT: Well, I think the justificationfor this investment is this: If andwhen the Soviet Union turns around,then McDonald’s will be there first.

But let me also say there’s notmuch evidence that this kind of ver-tical integration is effective. In fact,there is already a degree of verticalintegration in the large state-ownedenterprises in Eastern Europe thatmost of us, I suspect, would findastonishing. For example, Polish LOTAirways tends its own pigs in order tobe able to feed their employees porkfor lunch. There has been this huge—I would call it “cancerous”—growthin the size and scope of firms that hascreated just massive inefficiency. Andit has also bred a large bureaucracythat will resist any attempt at change.

So, if you want to privatize thesehuge state enterprises, it will involvefar more than just finding investorswilling to put up capital. In mostcases, it will require a complete re-structuring, a complete rethinking ofthe activities in which these firmsparticipate.CHEW: You mean you will first haveto break these huge companies intotheir separable parts?FROOT: That’s probably right, inmost cases. And, as Gary mentioned,there’s a real scarcity of managerialtalent and experience. Part of thisshortage arises from the fact that thekey managers within these firms havenot been given product or line re-sponsibilities, as in U.S. firms; insteadthey have been assigned to deal withspecific government agencies. It’s asif a U.S. firm told its CEO and topmanagers to spend most of their timelobbying in Washington. In Polishfirms, for example, one high-levelposition is responsible for dealingwith the Finance Ministry, anotherwith the Planning Ministry, and yetanother with the Pricing Ministry.

These people are essentially theequivalent of an American CFO, di-rector of corporate planning, or di-rector of marketing. Given that Polishmanagers have effectively been re-warded according to their ability tomanipulate the political system, it’sunderstandable that managerial ex-pertise in marketing, finance, or op-erations has not developed at all.

On top of that, as I mentioned,there are all these vested interestgroups resisting change. In everycountry, there are powerful peoplewho have a substantial amount ofcontrol. And, as Gary said, the prob-lem is political. They stand to benefitfrom blocking change. You can seethis clearly in the Soviet Union and inevery Eastern European country.

Starting Over with Small Firms?

CHEW: Well, given these massiveinefficiencies and resistance to changein state enterprises, wouldn’t it makemore sense for outsiders to build theirown businesses from the ground up?Perhaps you could build your ownorganizations just by pulling employ-ees out of existing organizations?LOVEMAN: This is what’s happen-ing. This is the good news in Poland.In the past, the Communists havebeen very effective at driving smallbusinesses out of existence; so, to theextent the small business sector ex-ists, it has been underground. Andbecause this economy is virtuallyinvisible, everyone’s attention inPoland has been focused on therestructuring of the large state sectorfirms.

But what’s happened since 1990 isthat the state sector has begun todisintegrate very rapidly, and theprivate sector has really begun togrow rather dramatically. We are see-ing the most enterprising people seek-ing the highest returns in the privatesector.


CHEW: In very small firms?LOVEMAN: Yes, in firms that mighthave, say, 50 people or, under themost remarkable circumstances, 500people. These firms have found prod-ucts or services the market wants;and they have discovered ways ofbuilding alliances with suppliers thatallow them to provide these productsat prices that people can afford. But,for would-be investors, the problemis that these entrepreneurial firms arehard to find. Such firms may bereluctant to take venture capitalmoney even when it’s offered be-cause they risk losing control.PETTY: But don’t these companiesrepresent a very small percentage ofthe GDP vis-a-vis large state-runmanufacturing firms?LOVEMAN: Oh yes, it’s tiny.PETTY: So they’re really not contrib-uting that much to a general recov-ery.LOVEMAN: That’s right. On the otherhand, every little bit helps, and it’sgot to start somewhere.MARTIN: An article in The Economistsaid that although there are some-thing like 1.2 million small or privat-ized firms, they accounted for only2.7 million employees. That’s onlyabout two employees per firm.BYGRAVE: Well, then, do these com-panies really need more capital? Ifthey had more capital, could theythen grow faster, and is that the besthope for the economy? What I’mhearing from you is that it is in thissmall private sector that the real en-trepreneurial talent lies.FROOT: In Poland, when you walkdown the street today, you just see amillion street vendors selling all kindsof goods that are hawked from thestreets of West Germany. The wholebusiness of retailing has been stimu-lated and undergone this dramatictransformation. But these are verysmall-scale operations.

But if you look at the Polish suc-

cesses on a meaningful economicscale—the products they have beenable to export to the world market—then you would think about lightmanufacturing of things like golf carts.These products are made by me-dium-sized or larger firms with sub-stantial capitalization, and these firmstoday have significant capital needs.BYGRAVE: Have any of those firmsbeen privatized?FROOT: No, most of them are still notprivatized. Very little progress hasbeen made in privatizing companies.BYGRAVE: So presumably the oppor-tunities for what we would call MBOsare very great. Are any MBOs goingforward, at least in the planning stages?

LOVEMAN: Mainly in smaller firms.BYGRAVE: If there were capital avail-able, though, would that make asignificant difference?LOVEMAN: No, I don’t think so.Again, the problem here is primarilypolitical. If you allow the currentmanagement to buy the companiesthey run, guess who the current man-agement tends to be? Communists. Infact, anyone in a position of power orauthority today is widely believed tohold that position arbitrarily; the cur-rent endowments, if you will, are allperceived to be unfair. For example,if you work for reasonably successfulcompanies like LOT or the PolishMerchant Marine, you are viewed ashaving either been lucky, or the re-cipient of political favor. Those com-panies will probably survive. But ifyou happen to work at the steel plant,your probability of success is zero.

So, if you allow people access tostate-owned assets on the basis ofwhere they happen to work or man-age, that’s a political nonstarter.FROOT: To even think about a solu-tion here, you have to separate thequestions of deciding on the owner-ship rights to existing assets and thekinds of financing mechanisms you’regoing to put into place to grow thoseassets that are productive. Thechanges in ownership of state assetsthat I believe will eventually be madewill involve some amount of widelydistributed citizen share ownership,some amount of worker control—albeit not a huge amount—and someamount of foreign participation.

But the most important questionhere is not how you divide up theexisting claims—although that obvi-ously is a very politically sensitiveissue—but whether or not you’regoing to have the kind of politicaland economic stability that’s going toencourage large infusions of capitaland thus provide the basis for futuregrowth. If you look at the history of

The key managers withinPolish firms have not beengiven product or lineresponsibilities; instead theyhave been assigned to dealwith specific governmentagencies. For example, onehigh-level position isresponsible for dealing withthe Finance Ministry, anotherwith the Planning Ministry,and another with the PricingMinistry. These people are theequivalents of the AmericanCFO and directors of planningand marketing. Since Polishmanagers have beenrewarded according to theirability to manipulate thepolitical system, it’sunderstandable that expertisein marketing, finance, oroperations has not developedat all.

—Ken Froot—


developing countries’ ability to at-tract capital inflows from abroad, thepreponderance of that investmenthas almost never come in the form ofprivate foreign direct investment.During the 1970s, it came primarily inthe form of commercial bank loansfrom developed countries.

So, I would argue that foreigndirect investment tends to followrather than to ignite the growth ofdeveloping countries. And this pre-sents a problem for Eastern Europe:Given that the international financialinstitutions and creditor governmentsin developed countries are not par-ticularly rich at this time, where ismoney going to come from to startgrowth off in the first place? Where isthe combustion going to take placeto start things moving?

Learning from Maquiladora?

WETZEL: Ken, both you and Garyhave spent a good deal of time inthese countries and observed thesechanges firsthand. Is there some-thing akin to the Maquiladora con-cept that could provide a workabletransitional model to get the wheelsof industry turning? What I have inmind here is sort of a partnershipbetween a Western European firmthat builds a plant on the border tomake use of low-cost Eastern Euro-pean labor. Would that overcomesome of the major objections andobstacles we’re hearing about here?LOVEMAN: I think it might work. I’vediscussed this possibility with peoplefrom The Limited. They have placesall around the world that make un-dyed cloth that they can then turninto dresses or shirts or whatever. So,could they do it in Poland? Yes. Butis it better to do it in Poland than inSri Lanka? Maybe not.

So, the issue is not simply can youmake it possible for this to happen inPoland, but rather can you attract

money into Poland that would other-wise be going to Mexico, Latin Amer-ica, or any other developing country.One of the great headaches for a guylike Bielecki is that every day there’sa new country, every one of which isgoing to compete with him for thelittle money and markets that areavailable.FROOT: Yes, but the Maquiladoraexample is one that’s predicated ongeographical proximity. The idea isthat you can integrate a depressedeconomy into a more vital one andspread the prosperity through trade.GRAY: But in Poland it’s actually theother way right now. It’s a “reverseMaquiladora.” They’re building ware-houses not in Poland, but in Ger-many right on the Polish border. Thisway they can sneak goods across theborder. And there’s a large and flour-ishing industry that does that everyday of the week.FROOT: Well, there’s also a politicalobstacle to this in the Western Euro-pean countries. Countries like Po-land, Czechoslovakia, and the Balticsall actually do produce a lot of agri-cultural goods. And they do so effi-ciently enough to wreak havoc withWestern Europe’s common agricul-tural policy.

So there’s not a lot of enthusiasm inWestern Europe for the idea of find-ing employment for some 30 millionworkers within a thousand kilome-ters of Berlin who will work for lessthan 50 cents an hour. These peopleare not going to be received withopen arms by either East Germans orWestern Europeans. That’s a realbarrier and a problem.

In fact, from the surveys I’ve seenof firms that actually have gone intoEastern Europe, those firms haveidentified their principal motive notas gaining access to cheap labor.Instead their response is, “We wantto get there first.” So it’s very much anorientation not of producing there

with the intent of selling elsewhere,but instead of getting there to securerights to local consumer markets.

And those are going to be slow-growing markets. Those countries arenot going to get rich rapidly. So theseexperiments of McDonald’s are goingto be banner kinds of investments.They’re way out-of-the-money strate-gic options, if you will. McDonald’sbet here is that the Republic of Russiais going to turn into the next Korea.PETERSEN: Other than in agriculture,do you have any sense of what Po-land’s comparative advantage mightbe five or ten years down the road?LOVEMAN: Well, Poland has a hugenumber of people, some 40 million,and a labor force of about 20 million.It has, by European standards, a mas-sive agricultural sector; and, as Kensuggested, they have a certain com-parative advantage in agriculture. Theyalso have this old textile sector inLodz, which has done reasonablywell—and they do export textiles. AsI also mentioned, the Polish merchantmarine is very effectively internation-ally, and has been for a long time.There is also a strong skilled craftsector in Poland, and the Poles havebeen successful in assembling con-struction crews and exporting them tobuild things in other countries. Theybuild bridges in Germany, for ex-ample. But there aren’t a lot of manu-factured durable products.GRAY: There is another political prob-lem, and that is the very large inflowof people into Western Europe fromall of the countries in Central Europe.It’s a flow of illegal immigrants, andthe Western Europeans are suddenlybecoming unusually sympathetic tosome of the immigration problemswe’ve experienced for decades—be-cause they’re now experiencing themin spades.FROOT: The most popular T-shirt inBerlin this summer had written onthe front of it, “I Want My Wall Back.”


GRAY: Unfortunately for Eastern Eu-rope, the folks who are leaving arethe ones endowed with the energyand risk-taking capability that char-acterize most emigrants. And thesepeople are exercising their powers,as immigrants do, by crossing theborder into Western Europe.LOVEMAN: At the same time, let meadd that Poland is actually receivinga large and continuous stream ofimmigrants from various parts of theSoviet Union. If you go to the Polish-Russian border, you’ll see many Rus-sian cars where people sit and sleepfor days and days, because the guardsonly allow a few in each day. Theycome in with their trunkfuls ofbabushka dolls and other things theywill sell in Warsaw. And then, oncetheir permit expires, they go back outand fill their trunk again and get backin the queue.

Angels in Eastern Europe

PETTY: What I’m hearing you all sayis relatively pessimistic. Is there anygood news?LOVEMAN: It seems to me—and thisis a very tentative argument—thatyou really have to start betting onindividuals rather than companies,because companies come and govery quickly. You have to find peoplewho have a demonstrated record ofsuccess and you have to be willing toinvest only relatively minor sums ofmoney. You don’t need massiveamounts of money. But you need tobe very patient.

Now, to proceed in this way wouldchew up a lot of Gordon Baty’s time.There has to be some reason whyhe’d be willing to go at it in this way.But I don’t see any other way.WETZEL: Sounds like an angel dealto me.CHEW: What is the potential role forangels in Eastern Europe? I’ve beentold, for example, that taxi cab driv-

ers have mattresses stuffed full of“hard” currency, and that they are aprime source of capital for new ven-tures? Or what about other informallenders like loan sharks—they havelow bankruptcy costs, or at least veryefficient enforcement mechanisms?LOVEMAN: Well, some of this is hap-pening. There is a car dealership inWarsaw that sells only the top modelMercedes and BMWs. There aren’tmany people who can afford to buythem, but there are some; and thesepeople are potentially very importantin the process of investment and inter-mediation in the country.

The problem is, there just aren’tenough of them. Remember, in Po-land you have a hyperinflation withannual rates of inflation of more thana thousand percent. This means thatanyone who held their wealth indomestic currency is penniless to-day. So it’s only people who’ve savedin hard currencies who were able toaccumulate any wealth.CHEW: But, today these people couldconceivably invest in these smallerventures with an informal set of prop-erty rights. They could perhaps de-vise their own enforcement mecha-nisms to make sure their claims areupheld.LOVEMAN: Today, if you were tostart a joint stock company, the prop-erty rights are clear. For the most part,that’s no problem. Where things getvery messy is when you get into theexisting state sector. That’s where allthe risk and uncertainty is.FROOT: Poland has passed a jointventure law and various laws onforeign investment, so that some ofthe laws are in place. But, as youmentioned, the bankruptcy side isvery underdeveloped.CHEW: So there won’t be any debtfinancing?FROOT: Who’s going to arbitrate theclaims you have when you go intosome kind of restructuring? The courts

don’t really understand the differ-ence between liquidation and finan-cial restructuring.

Now, from the legislative point ofview, property rights are in a sensedefined. But that doesn’t mean inves-tors will feel confident that their claimswill be upheld. Investors in U.S. com-panies today have considerable un-certainty about how their claims willbe upheld under the U.S. bankruptcysystem, but in Eastern Europe theuncertainty is much, much greater.

So things are still very much up forgrabs at every level; and that’s why thekind of activity you’re seeing rightnow is at the very, very small end. Forthese small operations, the legal andbankruptcy issues don’t really matter.CHEW: But is it conceivable youcould build up a large, privately-owned family business, like a Cargillfor example, which today has some-thing like $40 billion in assets?WETZEL: That may well be the onlything that is conceivable.GRAY: Yes, but take a look at theHungarian experience. They’ve ar-gued that for 20 years they’ve hadentrepreneurial successes. And al-though that’s partly true, such en-trepreneurism has not been permit-ted to grow into anything larger thansingle-family ownership. In 20 years,Hungary has produced some 5,000viable, entrepreneurial businesses.But most of them are relatively smallstorefront operations: delicatessensor restaurants or retail.FROOT: I think the whole experi-ment of Eastern Europe rises and fallsnot on whether these private com-pany empires are possible, but onwhether large-scale industry can bemade efficient and profitable. Largeindustry, after all, accounts for asubstantial fraction of employment;and, as I said earlier, the average firmsize is many times larger in EasternEurope than in the U.S. If the state-owned sector founders completely,


and unemployment across EasternEurope turns out to be very, veryhigh, then you’re going to have realpolitical problems—and, then, whoknows what?

Privatization Schemes

CHEW: Gary, can you tell us aboutthe Polish privatization plan, sincethat seems to be one way of attempt-ing to reform large state enterprises?LOVEMAN: The privatization planyou’re referring to is actually onlyone aspect of a larger scheme to selloff state assets in a variety of ways.Part of the scheme includes IPOs forsome companies; there have beenmanagement buyouts or MBOs forcompanies at the small end; and thenthere have been proposals for salesof those companies that are attractiveand large enough to support the costof having outside analysts come inand determine the value of the com-pany. In a few cases, however, com-panies have found that the consult-ing fees for all this analysis haveexceeded the sale price of the firm.

But here is the situation the Polishgovernment is faced with. There arecurrently seven or eight thousandstate enterprises in Poland not yetprivatized. The value of these compa-nies is falling virtually every day,because the workers are literallywalking off with the assets. The bestworkers and managers are going tothe private sector, and the state bud-get is an unmitigated disaster. Sowaiting any longer is not feasible.And not only do they have to actquickly, but they have to do it enmasse. They have got to find a way totransfer ownership of a very largenumber of companies to the privatesector in a single transaction, orthrough a single legislative act.

So what they have proposed is avery complicated scheme in whichthey will package together about 500

companies that have positive net cashflow and meet certain financial healthconsiderations. To invest in this groupof 500 companies they propose tocreate 20 intermediary funds calledNational Wealth Funds. Each of these20 funds will own a 33% stake in 1/20of the 500 companies, as well as smallpercentage stakes (about 3.5%) in theremaining 95% of the companies.CHEW: Is this designed to ensure thateach company has at least one largeowner who will serve as a monitor forthe other minority interests?LOVEMAN: That’s right. And thatbrings me to the ownership andmanagement of the funds. Accordingto the proposal, every Polish citizenover the age of 18 will receive a sharein each of those 20 funds. Theseshares will not be sellable for twoyears. And the expectation is that, inthe intervening two years, the fundmanagers are going to be out therebusting their tails to restructure thesecompanies that are in their portfolios.

The problem, however, is thatduring the six months that haveelapsed since this plan was proposed,instead of their being 500 companieswith positive net cash flows there arenow only about 300. That’s how fastthe economy is deteriorating. Thekind of reorganization and restructur-ing that this will require is enormous.And the Polish people will have to beeducated about what a share is, andwhat it entitles them to—because thereare not yet any tradeable shares in theconstituent companies. And then thereare other difficult issues: How do youevaluate and monitor the performanceof a fund manager when there are nomarket valuations of the firms he orshe oversees? And how do you findthe people to run the funds? Their ideawas that they could hire people likeGordon to come in and run thesefunds. They would find Westernersbecause only Westerners know howto do this stuff.

CHEW: Are Westerners lining up forthese projects? They’re going to haveto supply the expertise, and a lot ofit’s going to be free labor if the plandoesn’t work. And how much capital,if any, are these firms willing to put inupfront?LOVEMAN: Some firms have ex-pressed a willingness to think moreabout it. The problem is this: Imag-ine, based on the political reactionin the U.S. to corporate restructur-ing, what would happen if Gordonwalked into Lodz and said that hewanted to close five textile plants? Itwould not take long for that tobecome a political issue and Gordonwould quickly be sent on his wayback to Cambridge.

So I don’t think Westerners will berunning these funds. A more likelyalternative is that the funds will berun by Poles, with Western venturecapitalists and management consult-ants being hired on an advisory basis.And those Poles running the fundswill have a significant financial inter-est in the performance of the firms.FROOT: These fund managers willhave to be a kind of hybrid between aventure capitalist and a portfolio man-ager; they will have very active roles insome individual companies, but theywill probably not end up pumping a lotof money into the Polish economy.Their real job will be to revitalize theeconomy by moving labor out of hope-less industries, closing down outmodedplants, and finding productive uses fortheir existing resources.CHEW: So there’s no proposal fornew money in this scheme?LOVEMAN: That’s right. But the pro-posal would give these people thepower to raise money from outsidesources. To the extent that such moneyexists, they could certainly go out andraise debt financing. The question ofequity financing is tricky, however,because as soon as you raise the issueof outside equity, you disturb the


ownership structure that they’veworked so hard to try to gain accep-tance for among the Poles. But thebigger question is whether anyonewill provide new equity for thesefirms under any circumstances.WETZEL: Aren’t there a couple of bigEastern bloc pools that have been puttogether by Salomon and people likethat? What are they doing with thatmoney?LOVEMAN: I don’t know, I’m notfamiliar with what Salomon’s doingthere. A lot of the money that peoplehave put together in places like theWorld Bank and the European Bankfor Reconstruction and Redevelop-ment has gone largely for “technicalassistance,” which means paying con-sultants to come in and help out withwhat ought to be done.

But the odds that even this priva-tization proposal—and you can imag-ine what it would be like to try toexplain this to your average Polishfarm worker—the odds that this willfly politically are fairly small. And if itdoesn’t, there’s really nothing aroundto replace it. So I’m very pessimistic.CHEW: But why wouldn’t this pro-posal fly if there were going to be agenerous representation of Poles onthe boards of all these mutual funds?LOVEMAN: The problem is, if you’vejust spent the last 15 years of your lifetrying to get out from under authori-tarian rule, you’re very unlikely to letother people come in and take thatjob again. They’re going to insist onsome system of checks and balances.There have been several scandalsalready among financial institutionsin Poland. There was what amountedto a kiting scheme in Poland that theyhad no capacity to detect until itbecame clear that someone had man-aged to expropriate a sum that wassomething like 2% of the GDP. As aconsequence of things like this, there’stremendous skepticism about givingpeople real power, the power that

will be necessary to restore efficiencyin these companies.

The Ultimate Free MarketSolution

MAGEE: Given that these old partymembers are still running the show inmost of these countries, it seems clearthat until they’re out of the way thatnot much is going to happen. Thesepeople have a vested interest neitherin leading the way for change noreven in just getting out of the way.And if the whole free market experi-ment collapses, then they’re right backin business. Is there any sign that thebureaucrats are being dislodged?

LOVEMAN: They’re certainly not outof the way. In Poland they occupy themajority of the seats of the Parliamentuntil the 27th of this month. And theycontinue to have most of the man-agement positions in the major firmsin the state sector. They have a tre-mendous amount of power.BATY: It sounds like Poland doesn’thave any problems that the U.S. capi-tal industry can do much about. Isthere any other country in EasternEurope with better prospects?LOVEMAN: Poland is actually betteroff in the sense that it doesn’t havethese ethnic rivalries that are tearingsome countries apart.FROOT: I would have guessed thatHungary and Slovenia are probablyamong the top places where therereally is an existing stock of humanresources, people who really under-stand what it means to produce forand sell to a market.BYGRAVE: I think Slovenia would bea huge success if it wasn’t for thisdamn civil war. They have consider-able entrepreneurial experience, interms of world markets, in terms ofraising money, in terms of manage-ment. And in fact the civil war’s reallybeing fought over that issue: Croatiaand Slovenia are much wealthier percapita than the rest of the country.FROOT: Yes, that’s right. Sloveniahas ten times the per capita wealth ofthe rest of Yugoslavia. One reasonwhy at least parts of Yugoslavia func-tion well is that the country has beenon a market-based system for sometime. And so, assets weren’t crazilyallocated for long periods of time, theway they were in Poland and theother Eastern European economies.But, in Yugoslavia you do have ex-actly the same problem as far as theBolsheviks being in control of themajor banks, the major companies,and in appropriating capital as theyliked, before these legal questions ofownership are fully resolved.

There may be some importantconstraints on the growth ofliquidity in risk capitalmarkets. If you put out an IPOtoday and the stock price goesdown, you will get sued byinvestors, be dragged into thisnightmarish legal quagmire,and incur enormous costs.These law suits have nothingto do with violations of thelegal code, they’re just sheerlitigiousness brought on bydisappointing results.Investors are using our legalsystem to get rid of theirdownside risk. If you havethis huge legal liabilityassociated with anything thatfails—and remember thereare supposed to be failureshere—then these markets willgrow less rapidly andliquidity will suffer.

—Steve Magee—


PETTY: What about the Baltics?FROOT: The Baltics are just in realdisarray. The thing about the Hun-garians and the Slovenes is that theyunderstand well their capacity, atleast in principle, to export to West-ern Europe—and they are doing it.But it’s hard to imagine a rapid turn-around in the Baltics because somuch of the infrastructure has beendedicated for so long to trade withthe Soviet Union.LOVEMAN: There was a recent studyby George Akerlof and his colleaguesat the Brookings Institute that sug-gested that, given current prices andthe one-to-one parity of the WestGerman and East German currencies,less than 10% of East German firmshave any chance at competing in thenewly unified Germany. And you’vegot to remember that East Germanywas widely thought to be the best offof all of these countries, as well ashaving the benefit of close ethnic tiesto West Germany.FROOT: One major problem at thispoint, though, is that so many poli-cymakers across Eastern Europe arelooking at the East German example

and are concluding that it’s a reasonnot to plunge ahead with drasticchange, but rather to take a gradualapproach to change. But, meanwhile,as we’ve observed, the assets arebeing stolen and conditions are rap-idly deteriorating.

And I think the interpretation that’sbeing put on the East German expe-rience is incorrect. The problems inintegrating East Germany are reallybeing driven almost exclusively, inmy view, by the insistence on wageparity between East and West Ger-man workers. The socio-economicproblems associated with bringingback some part of what was formerlythe nation, and having garbage work-ers demand that they get paid thesame in the east as they do in thewest, simply wouldn’t exist in Po-land, Czechoslovakia, or any of theseother countries. And so the likeli-hood of large-scale unemploymentresulting from a rapid, decisive tran-sition to a free market economy is alot lower. On the other hand, there’sonly so low wages can go and they’renow pretty close to that level in manyof these countries.

WETZEL: Well, when everything isstolen, privatization will be complete.LOVEMAN: It’s true. One proposalthat people typically make in jest isthat the best thing the Poles mightactually do is to just let it happen—just let the state sector be dismantledpiecemeal by the workers, and thenlet free enterprise rise up in thevacuum. This way, you can just startover with what’s left and avoid all thepolitical pain of this privatization.MARTIN: It seems to me that thewhole problem may stem from thisparadox that the Poles are trying toohard to manage their move to anunmanaged economy. Maybe thebest solution is to quit managing themove. Maybe they should just let italone, let it burn down, and some-thing better will rise up in its place.GRAY: Well, these huge bureaucra-cies that have managed things totallyfor years are seeing the disappear-ance of their reason for existence.They’ll fight it tooth and nail.MARTIN: That’s why I say this may bethe only way; it may be the only wayto get rid of the bureaucrats. Let theemployees take it home.

ROUNDTABLE ON U.S. RISK CAPITAL AND … · WILLIAM BYGRAVE is the Frederic C ... is the Fred H....

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