Boom Time in Venture Capital

By Alexander L. Taylor III

Moneymen are risking more cash than ever on daring entrepreneurs

The most elite club among American financiers is the strong fraternity of some 1,000 people running venture capital firms. These are the investors who typically will give $1 million or more to often untried businessmen to form companies in microelectronics, genetic engineering, robotics or other industries. The field is highly risky; an estimated half of all such initial investments are eventually written off as tax losses. But for winners the payoff can be huge: a $1 million investment might return $100 million.

Venture capitalists prefer to tell tales of their big scores: the $1.5 million stake in Apple Computer in 1978 by Venrock Associates that grew to $100 million or the $25 million investment in 1974 by New Court Securities Corp. and others in Federal Express, the airfreight company, that is currently valued at $1.2 billion.

Buoyed by those and similar recent successes, venture capitalists are investing money ever more rapidly on ever more exotic business proposals. Last year 145 new companies were started with venture capital, 53% more than in 1979. By year's end, according to Stanley Pratt, editor of Venture Capital Journal, these companies will have poured a record $1.1 billion into infant businesses. Says Pratt: "This is still a minor blip in the capital structure of this country, but it is a critical amount for the American economy."

Venture capitalists provide much of the seed money for U.S. business. By giving out start-up cash to farsighted entrepreneurs, they can open whole new areas of business enterprise. Venture money has fueled the development of the computer industry through investments in Prime Computer, Cray Research, Tandem and other companies, helped spark airline industry diversification with People Express and Air Florida, and bankrolled infant gene-splicing companies like Genentech and Biogen.

Usually, venture capital firms take a block of stock in exchange for start-up money in a new company. The venture capitalists may own as much as 60% of a firm's outstanding shares, which then often jump in value when the new company goes public.

Sometimes, though, the venture money disappears. Some recent failures: Ruben Engineering Corp., a Cambridge, Mass., office equipment firm that cost its backers $4 million in losses; Ontrax, which went through $1.5 million trying to make computer disc drives; and Environmental Development Corp., which spent at least $1 million in venture capital trying to sell waste-water-treatment services to cities.

The bold moneymen look for entrepreneurs who cannot get funding from bank loans, new stock issues or other conventional sources. They also usually seek out firms in the forefront of a new industry. The odds may be long, but the return can be high. Says Donald Ackerman, 47, senior partner of New York's J.H. Whitney.& Co.: "One large winner takes care of a lot of mediocre situations and even an occasional loser. This is not a game for little investors."

It takes tough analysis, savvy business sense and the daring of a high-wire walker to sort out the possible winners from the almost certain losers. Says George Rooks, 45, president of First Capital Corp. of Boston: "In the final analysis, it boils down to educated instinct--call it judgment. What we make is a judgment on the people and the product." For instance, Boston's TA Associates and New York's Inco Securities have raised $3.5 million to start a new company called Immunogen Inc. The firm plans to develop the use of monoclonal antibodies, which are invisible bits of protein that could be used to carry toxins that will specifically attack cancerous and other diseased cells, while leaving healthy ones alone. Although the technique remains unproved, the company looked like a good bet largely because its research staff is headed by a Nobel prizewinner and includes faculty members from Yale, Harvard and M.I.T.

The management of the new company is usually regarded as even more important than the product.

Says William Burgin, a partner in New York's Bessemer Venture Partners: "We prefer to invest in people with a track record, or we find a good manager for someone who comes up with a good idea." One such person was Irving Tague, who had been general manager of Hughes Airwest, a West Coast airline. Tague headed a group of executives that founded Chicago's Midway Airlines in 1979. The company, which was launched largely with $6 million in Bessemer venture money, earned more than $3.4 million during this year's second quarter alone.

Venture capitalists generally avoid investments in entertainment, such as Broadway shows, real estate or oil drilling. Says Burgin: "The potential sales have to be in the $100 million range. We can't invest in fads."

The work of these bankrollers does not end with an investment of $1 million or so in start-up money. They must then spend perhaps five to seven years nursing along the company with judicious management assistance and usually additional money. In 1969 Whitney helped start Storage Technology Corp. of Louisville, Colo., with an investment of $500,000. The company, which makes advanced computer accessories, had troubles for years until Whitney put one of its people on the company's board. Five years ago, Storage Technology's business finally began to grow as expected, and today it has annual sales of $603 million. After the company sold its stock to the public, Whitney's initial investment produced a return of $50 million.

The old oil and steel fortunes of families such as Rockefeller, Whitney and Phipps provided the bulk of the money for the venture capital market until the early 1960s. The Phipps family's fund, Bessemer Venture Partners, was an early investor in International Paper and Ingersoll-Rand. Laurance Rockefeller in 1938 helped start both Eastern Air Lines and Douglas Aircraft. When younger members of the Rockefeller family decided that they wanted a part of the action, a broader risk fund called Venrock was created in 1969. It has since made lucrative investments in both Intel, a successful semiconductor manufacturer, and Apple Computer. One venture that did not work out was Advent Corp., which filed for bankruptcy when its big-screen TV sets did not sell. Admits Managing Partner Peter Crisp, 48: "We have some companies that have lost money, of course, but no really big bloopers."

Throughout the 1960s, however, money from large banks and corporations joined the old family funds. Citicorp,

Bank America Corp. and other bank holding corporations began to create small business investment companies to fund new ventures. Lured by the potential profits, large corporations, including Exxon, General Electric and Texaco, also started setting up venture capital subsidiaries. In addition, pension funds, insurance companies and universities with large endowment funds began looking for new companies as a way of earning a higher return on their pools of cash. Big banks, corporations and other institutions now provide 83% of all the grub stakes for new firms. The venture capital firms owned by families still seek out the riskier startups, while major companies and banks frequently provide money for the second or third round of financing.

The current boom in venture capital is in sharp contrast with the situation in the early 1970s. At that time, a plunging stock market, the failure of scores of high-technology companies and federal tax increases on capital gains almost dried up the venture capital market. The money faucets again began to open up three years later with the passage of a new tax bill that lowered the rate on capital gains from a maximum of 49% to 28%. The amount of fresh capital immediately jumped from $39 million in 1977 to $570 million in 1978.

The flood of new money and the well-known success stories have created intense competition to find and fund new ventures. "Five years ago, we could take a month to study a company," says Bert McMurtry of California's Technology Venture Investors. "Now we have to be prepared to do the work in a couple of weeks." No longer can a financier sit in his office and wait for businessmen to come to him. Some regularly stroll around new industrial parks and poke their heads through doors to look for companies that have barely had time to hang out a sign.

Nowhere is the venture capital pace faster than in Santa Clara County, Calif., where genetic-engineering firms are growing up alongside already successful semiconductor manufacturers. The area once known as Silicon Valley has now been dubbed Siliclone Valley. Over the past ten years 28% of all U.S. companies that received venture capital financing were based in California.

Sutter Hill Ventures, a Palo Alto fund with investments in 50 companies, measures the health of its business by the daily mail. Between 1973 and 1978, it received about 250 financing proposals each year. This year it expects to receive 400. The quality of applications is improving too. Says Sutter Hill Partner G. Leonard Baker Jr.: "During the slack times, we were seeing people with very few alternatives for finding new money. Now we're seeing an explosion of entrepreneurs."

One of the most successful venture capital firms in California is Kleiner, Perkins, Caufield & Byers of San Francisco. This is neither an old wealthy family firm nor a subsidiary of a major corporation. The company is rather using the gilded reputation of past successes to raise large new pools of money for fresh investments. Started in 1972 by Eugene Kleiner, one of the founders of Fairchild Semiconductor, and Tom Perkins, a former Hewlett-Packard executive, the company has seen its initial investment fund grow from $8 million in 1972 to almost $300 million today.

Kleiner, Perkins closely studies an infant company's prospects and then carefully nurtures it during the early years. In 1973 Jim Treybig, one of the partners, began to work on an idea for a new computer that would eliminate many common computer breakdowns. Last year Tandem Computers, with Treybig as president and Tom Perkins as chairman of the board, rolled up sales of $109 million. The $1.5 million investment by Kleiner, Perkins is now worth $220 million. The company also struck gold last year when Genentech "One large winner takes care of an occasional loser.

Inc. went public. Genentech was founded by Robert Swanson, another former partner, sand Biologist Herbert Boyer. Today, Swanson is the president of Genentech, while Perkins is the chairman. The initial $200,000 put into the firm has swelled into stock worth $40 million.

The masters of venture money, however, must be patient. Since 1972, Kleiner, Perkins has been bankrolling Andros Inc., a small company that hopes to market an artificial heart. So far, the young firm has shown no profit.

The long development time and the potential for failure help explain why venture capital funds have had little appeal for small investors. Although the public can buy about two dozen venture capital mutual funds, these have not been popular. Says industry expert Stanley Pratt: "People should not expect these new companies to grow like weeds. It will take a long time for an investment to mature." Pratt advises the small investor who is interested in such firms to buy their shares after the new companies make their first public offering.

All the new investment activity has made it much easier for clever entrepreneurs to raise money. Several months ago, two West Coast venture capital companies were ready to put up $3.5 million in exchange for a 60% stake in a new firm specializing in X-ray photo lithography, which is used in semiconductor manufacturing. Then a third company heard rumors of the impending deal, made a hurried study and offered the firm $7.5 million for only a 50% interest. It was eagerly accepted. Amgen, a genetic-engineering company founded by a molecular biology professor from U.C.L.A. and a vice president from Abbott Laboratories near Chicago, raised an astonishing $19 million earlier this year. That was the third largest amount ever given to a venture firm. Although the initial risk and rewards of venture capital belong mostly to the small select club of moneymen, the eventual winner will be the entire U.S. economy. The innovative companies that venture capitalists find and then foster will manufacture new products, provide jobs and increase productivity in the industries of the 21st century. Today's startups, which have names like Hybritech, Thermo Electron and Collasen, may some day join Eastern Air Lines, McDonnell Douglas and Apple Computer as the success stories of venture capital. --ByAlexander L. Taylor III.

Reported by MichaelMoritz/San Francisco and Frederick Ungeheuer/New York

With reporting by MichaelMoritz, Frederick Ungeheuer

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