Economy: The Return of Venture Capital

In this week's cover story, NEWSWEEK business columnist Daniel Gross writes about the "safety bubble": the dangers of Americans turning too abruptly to too-safe investments after a generation of risk-friendliness that powered the U.S. economy. Avoiding risk feels like the right thing to do these days, but it does carry consequences. One of these can be found in the venture-capital industry, which appears paralyzed—with the stock market in the dumps, startups fear they can't stage successful IPOs, and they have similarly bleak hopes of a lucrative purchase by a bigger corporation. Afraid they won't realize a return, the institutions and wealthy individuals who invest in venture funding are pulling back their infusions of cash. That, in turn, means more fledgling startups are struggling to find enough capital to grow.

It's a bad cycle, especially given the historical role of innovation and entrepreneurship as the lifeblood of the U.S. economy. From Cambridge, Mass., to Menlo Park, Calif., venture capitalists are riding out the storm. This week, several spoke to NEWSWEEK's Nick Summers. Excerpts:

Tony Conrad, venture partner, True Ventures:
Summers: What's the state of the venture-capital industry?
Conrad: Like anybody you talk to, we all think this is quite severe. And it's still quite fluid; we're not really sure where it all knits out. Nobody's being flippant and suggesting that this is just a little short-term cycle and things will be back to a really good spot. This one's a little different than what we lived through in 2000 and 2001—what I call "the dress rehearsal." Then, it was the tech market that dragged down the overall. In this case, the tech market is pretty healthy and is being dragged down by the general economic backdrop.

What will happen in the next few months or years?
From our vantage point, the current correction—we don't want to go out on a limb and say it's a great thing, but it's not a bad thing from our point of view. What would be a bad thing is if, five years from now, you and I are having the same conversation. No matter how deep our checkbook is, that's problematic for everybody.

Is there reason for optimism?
It's a great time to start a business in a down cycle, because if you manage your capital efficiently and build the right infrastructure, hopefully, as that business gets healthier and gets in a position to become well-capitalized for the right reasons—because it merits being capitalized—you're emerging in a market that's starting to open up. There's optimism, and the loosening of the checkbook, and the capital flows.

Arnie Oronsky, managing director, InterWest Partners
Why is venture capitalism in trouble right now?
In order to make venture capital work, you have to put money in, build companies and then get out of the companies, either by getting them public or selling to bigger companies. A major way to do this is to get it public. There is zero opportunity to take companies public today. So one extremely important source of money to build a company to profitability is now gone for the moment.

If investors are becoming reluctant to back VC funds, what's the implication for the whole economy?
Venture capitalists are the highest-risk investors, the highest-risk people. If a venture capitalist is starting to get risk averse, this is like an unbelievably bad sign. Because if the venture capitalists don't want to take a chance, I don't know who in the world would.

Is there reason for optimism?
Prices are good now. The value of technology, the value of life-science companies, is dropping. And if you want to put your money to work, and you have nerve, this is the right time to do it.

What's the long view?
Some of us, like InterWest, that have been around long enough to live through a number of these cycles are likely to be somewhat less risk averse. Because as a venture capitalist, you have to be optimistic, have a long-term view and have enough experience to know this cycle will disappear. Whether it comes back to where it used to be, or slightly lower, or how long it will take, no one knows.

What's the relationship between risk, innovation and the economy as a whole?
In terms of going forward and building the country, risk aversion, in times like this, is actually not good. It's not good for the venture-capital community to be too risk averse, because then you stifle entrepreneurship and innovation. And whether you like it [or not], innovation goes on. It's going to continue. People have ideas, great ideas. To stifle that, because there isn't the funding around to take advantage of it, is not the American way. I don't want to sound like a politician, but I believe that.

Silicon Valley has driven the American economy for quite some time now. And I think it would be a drastic error to pare that down, to depress innovation, because we have to do this to succeed. We have the kind of culture and society that can do it. Because it engenders, that whole thought process is building new things; entrepreneurship is fundamental to the American culture.

Is there angst in the industry about the venture-capital business model itself?
Yes. At other points in time you could, with some surety, say if you picked the best venture-capital funds, you'll make money. In the blackness, the way it is today, the people who invest in venture funds, who are called limited partners, they do have concern that the whole system is—I wouldn't say broken, that's not the right word. But you now have to be much more careful than you were before.

There is angst in the system for sure, there's just no question about it. And the angst goes all the way through the system. If your limited partners are worried, it definitely flows through to you.

Tim Draper, managing director, Draper Fisher Jurvetson
What are some of the issues facing the venture-capital industry right now?
We currently are stuck with regulations that were created for big business that have been foisted on small businesses, like Sarbanes-Oxley compliance, which costs these small technology companies about $3 million per year, [and many others]. [There is] a plethora of other seemingly minor—but, taken as a whole, overwhelming—regulations. In addition, a near-monopoly situation in the IPO business has brought it to a standstill.

Finally, the discussions of possible double taxation on capital gains is making investors more wary of taking risks with their hard-earned and already-taxed-once income. This could have the effect of altogether eliminating most of the angel money.

We are faced with undue regulations better suited to much larger companies, a difficult liquidity situation, an accounting-standards board with no sense of the negative effects their rules are having on entrepreneurship and a legislature seemingly determined to kill small business wherever it lives. Still, I believe the entrepreneurs of the world will eventually overcome even these obstacles. But if it gets much worse, they will have to leave this country to do it.

Is there angst in the industry that the venture-capital business model itself might be flawed?
There is nothing flawed about it. The venturecapital business is the best-known method for job and wealth creation there is. There is nothing like the alignment of interests between a venture capitalist and an entrepreneur.

The venture-capital business is cyclical, and it is the business that creates the jobs, optimism and wealth that has led us out of recessions in 1974, and 1991. I believe we can do it again. The business model works, and the market will come back big for venture capital. A friendlier regulatory environment would help.

After a generation of being risk-friendly, have Americans become too risk-averse too quickly?
Well, I don't like seeing the media spread fear. It is more powerful to spread opportunity. I think people should generally take more and bigger risks than they do to make a positive contribution to the world. The U.S. used to have a near monopoly on risk-taking, and our country grew fast and benefited greatly from the reputation, but now our government is in competition for the great risk takers (and the risk capital) of the world, and the environment here for risk takers needs to be improved.