A ten-year study follows the venture capital business from relative obscurity to boom to retrenchment
Paul A. Gompers and Josh Lerner are professors of business administration at Harvard Business School. Paul Gompers also serves as a director of research at that institution.
UBIQUITY: When did you finish writing The Money of Invention?
GOMPERS: We started the project before the substantial decline in stock prices in technology stocks, but wrote it after the April 2000 correction, largely completing the manuscript between the summer of 2000 and the summer of 2001. As a result, we were able to provide perspective both on the boom period and the subsequent retrenchment.
UBIQUITY: So how would you describe the state of venture capitalism right now? It's not overheated, to be sure. Is it icy cold?
LERNER: Well, one point to emphasize is that the venture business is one that's always had a strong cyclical element to it. In particular, one of the key elements seems to be that there's a process of undershooting and overshooting, and that during periods when there's a lot of activity and a lot of interest, there's typically been a dramatic influx of funds. In fact, in many cases it seems that the level of funding reaches a level that's too high to be really sustainable -- this was true for the 1999 - 2000 period, the early to mid-1980s, and the late 1960s. But at the same time, there is the other phenomenon that we call undershooting, where there's an overreaction the other way -- too little venture capital is raised. So there is a definite ebb and flow in terms of activity, and it's clear that now we're in one of those periods of retrenchment where groups are looking at their portfolios and raising the bar in terms of new investments they're considering funding.
GOMPERS: In terms of the current state of the market, it's clear that we're still seeing lot of money being invested in the sector. If you compare the dollars that were spent in the first three quarters of 2001 to any year other than 2000, it looks very, very good. But, as Josh suggested, there's a big difference between getting follow-on funding and getting initial funding. Seed-stage and early-stage capital are tough for entrepreneurs to get right now.
UBIQUITY: What would you tell software developers who seem to have a pretty good new idea? What's step one?
LERNER: The two key things that they need are a clear vision of the market and a real sense of the path to profitability. During 1999 - 2000, an awful lot of companies that were not very well thought through (to put it charitably) were getting funded anyway -- and there's a little bit of that residual mindset on the part of some entrepreneurs who say, "Oh, we don't really need to get everything perfect here, we just need to go out and tell investors what a great opportunity we're offering." That won't work any more. Entrepreneurs now need to be very careful about assembling their team and cogently articulating the business opportunity.
GOMPERS: The second thing is that entrepreneurs should go into the fund-raising process with a clear notion that they aren't going to be receiving the attractive valuations that their friends got 12 months ago. Valuations have come back down to reality because some of what we saw in the marketplace was not sustainable.
UBIQUITY: Do you often find entrepreneurs aggressively changing their whole notions to reflect what they perceive as the winds blowing in a different direction? For example, do they suddenly rush into the security business now, when they weren't really in it before?
LERNER: Yes. For example, one of our friends, who had an Internet company that couldn't get funded, now has a bioinformatics company. So it seems that there is a little bit of that sort of strategic repositioning taking place. But in some sense, that's really the entrepreneurial process. One of our former colleagues, Amar Bhide, argues that when you look at almost any successful entrepreneurial company, you find that it reinvented itself several times over before it got things really right. Of course, there's always the question of whether or not that kind of wind tacking is good or bad for the overall economy. We saw all these waves or fads run through the technology sector in the late '90s, and it's one thing if those waves are real opportunities but quite another if they're being driven by the opportunity du jour. You can't turn a duck into a gazelle.
UBIQUITY: Let's change the focus from the entrepreneurs themselves to the VCs and the incubators.
LERNER: Those are two very different worlds you're alluding to. We don't deal in the book directly with incubators, but it's fair to say that by-and-large it's a pretty ugly scene for most of the incubators that were set up. The vast majority of them were created very much in contradiction to the principles that successful venture groups have employed over the years.
UBIQUITY: In what sense?
LERNER: In the sense that many of them were managed by very inexperienced people who didn't have disciplined approaches in terms of investing in portfolio companies. There often was a lack of focus in terms of the companies that they got involved in supporting. So it's really not surprising that a lot of them ended up as fiascoes.
GOMPERS: In terms of the venture industry itself, one of the interesting things we found is that, while the industry finances innovation by others, the venture industry itself has not innovated very much over the last 50 years. What is changing today is that current market conditions have put pressure on venture firms to rethink the way that they do business. Many of the best groups are thinking about doing what we term the "professionalization" or "institutionalization" of the venture capital firm. The questions include: How do we share best practices, how do we organize the business, how do we think about division of responsibilities and decision-making? Most groups have not gone through the process of thinking about how a venture capital firm should be run. The best groups now are taking the opportunity to step back and think about that question.
UBIQUITY: One of the most interesting discussions in The Money of Invention is focused "emulators." Talk about that concept.
LERNER: Over the years, dating back to the 1960s, there have been efforts to try to create hybrids between corporate R&D laboratories and venture capital firms. And though these efforts have led to a few positive experiences, there have been numerous misadventures along the way. So in our book we've tried to distill some of the lessons for successfully emulating the venture capital model; that is, translating the venture model from the traditional venture firm into other organizations.
GOMPERS: In its most fundamental aspect, the problem is: How do you bring resources to bear on innovation? There are a lot of groups out there -- from corporations to public policy makers to universities to government research facilities -- that face exactly the same problem, which is that they see innovative activity going on and would like to create value from that innovation. Yet the problems that have faced the entrepreneur throughout the ages are burdens to these entities as well.
UBIQUITY: But money's not the whole answer to the problem of making innovation flourish, right?
GOMPERS: Right. It's a mistake to throw huge amounts of money at an innovative project that has either low potential or an uncertain potential. So the first question is: How do you screen out the best projects? Then, once you've identified the best efforts and you've gotten a second opinion to corroborate their judgment, how do you structure the investment to maximize the incentive of the entrepreneurs to make sure that they're aligned with the person providing the funding? How do you monitor progress along the way? How do you set benchmarks? How do you stage the investment of capital? What are the key decisions that should be made by the entrepreneur? And what are the key decisions that should be made by the investor? The heart of the matter is that you're right -- just throwing money at an innovator is not the right way to go. The way to go is to have deals screened and monitored, investments staged, and decisions made along the way, as is done in the venture capital process.
UBIQUITY: What kinds of groups are doing this best?
LERNER: Among the groups I think are doing the best job today are the ones with less traditional kinds of strategies. These groups essentially are trying to build out their brands, for example, by trying to invest both in the United States and in Europe, and building their scale.
GOMPERS: You have to go around the food chain and look at not only the interaction between the VCs and the entrepreneurs, which we've been talking about, but also at what's happening between the VCs and their investors. Because it's fair to say that the large institutions -- the endowments and the pension funds and the foundations that gave a lot of money to the sector -- are concerned as well. And the chief investment officer for private equity at some pension fund is probably a little scared right now, so the better groups are actually communicating -- or at least not trying to hide the investments that are troubled.
UBIQUITY: In The Money of Invention, what do you say about the issue of scale?
LERNER: What we argue is that we're likely to see a period of consolidation or shakeout in the private equity industry, and the number of actors in the business probably will be reduced. Furthermore, we argue that the differential between the firms in the top quartile and the median firm will widen quite dramatically.
UBIQUITY: Well, let's try to put you in the prediction business. What would you expect to find 10 years from now in the industry?
GOMPERS: I think 10 years from now you will find that the organization of the venture industry will be different -- that there will likely be a number of top-tier firms that have a greater concentration of the capital, and many of these firms will operate on a global basis. These firms will have built out infrastructures for helping portfolio companies in numerous areas. These firms will have developed a professional structure to share best practice, and rethought the questions of corporate governance and decision-making. Over the next 10 years we'll see a transformation from an industry where the principals operated like artisans into one that's organized as a professional service firm. There clearly will still be many other players in the market, but they'll be more of a competitive fringe.
UBIQUITY: As you did the decade's worth of research that went into this book, was there anything that you were hugely surprised by? Did you learn anything that was really surprising to you?
GOMPERS: One of the most interesting things we found was the sheer magnitude of the impact of the venture industry on the economy. One of the interesting things for me was actually putting all the numbers together and realizing that the venture industry relative to corporate investment is a pretty small piece of total economic investment, yet at the same time it's had a disproportionate impact on wealth and jobs and innovation. And those numbers we assembled for the book were genuinely surprising to me.
LERNER: I think the biggest surprise has been the rate of change. When I started doing research for my thesis in 1989, everyone thought I was focusing on a totally obscure industry that no one would ever be interested in and tried to convince me that I was engaging in professional suicide to research it. I guess the biggest surprise is that they weren't right. I'm glad.