TCS Daily


A Bridge to the Next Tech Boom

By Dominic Basulto - December 16, 2002 12:00 AM

The venture capital industry, which bankrolled the dot-com euphoria of the most recent technology boom, shows relatively few signs of returning to its former prominence anytime soon. Total VC investment has now declined for nine consecutive quarters, and threatens to dip below pre-1998 levels. After investing $100 billion in 2000, VC investors only invested $40 billion in 2001, and through the first six months of 2002, have only invested $10.8 billion. As can be expected, a lot of discussion has centered on the boom-and-bust cyclical nature of VC funding, especially as portfolio returns continue to dip into negative territory.

When will the VC cycle stabilize and reach a new equilibrium and - more importantly from the perspective of cash-strapped entrepreneurs - when will start-up firms once again start receiving VC financing? Most analysts focus on a number of factors, such as the trajectory of the public equity markets, economic fundamentals such as GDP or productivity growth, or even the latest soothsaying by Fed Chairman Alan Greenspan. The consensus opinion appears to be that underlying economic growth will boost the public equity markets, which will then provide a spark to the private equity market.

A recent paper ("Financial Intermediation as a Beliefs-Bridge Between Optimists and Pessimists") presented at a Yale School of Management private equity conference this year, though, proposes that there might be an easier answer, related to the level of optimism in the economy. According to the paper's model, any VC boom arises by exaggerating small underlying shifts in the quality of entrepreneurial projects. As the quality of projects increases, the percentage of funded VC projects that actually succeed increases, leading entrepreneurs to become more optimistic. At a sufficient level of optimism, VC firms are able to build a "beliefs bridge" between investors and entrepreneurs, and the investment cycle begins.

Joshua Coval, a finance professor at Harvard Business School, and his colleague from the University of Michigan, Anjan Thakor, theorize that the major players in the VC investment cycle can be thought of in highly stylized terms. There are optimists, there are pessimists, and then there are rational agents: all three of them are risk-neutral, but have varying degrees of optimism about the economy. Financial intermediaries - such as VC firms - are simply coalitions of rational agents raising money from pessimistic investors and funding optimistic entrepreneurs. VC firms serve a specific role: they screen projects and design contracts that can attract money from investor-pessimists.

What Factors Contributed to the VC Funding Bust

The Coval-Thakor model provides an explanation for the VC funding cycle. In short, too much optimism led to BOTH the boom and the bust. As the level of optimism in the economy increased starting in 1998, the VC industry became a victim of "excess intermediation": too many people competed to finance new start-up ventures. The numbers bear this out - the level of VC investment increased from close to $20 billion to $100 billion within a three-year time horizon and the number of VC firms proliferated from 1,000 to 2,500. Instead of long-time industry veterans such as Kleiner Perkins and Charles River Ventures leading the VC investment cycle (the so-called "rational agents"), there was an explosion of smaller firms with no track record and no private equity investment experience.

At a certain point, too many "non-skilled" intermediaries with no ability to screen projects started to enter the fray, leading to a case of "too much money chasing too few good ideas." Once this happened, bad projects started to crowd out good projects. The classic example of a "bad project" used in the article is Pets.com. Joshua Coval elaborates on this point: "When opportunities are good, at a certain point, VCs no longer carefully screen projects, either because they have become optimistic themselves or because they have so much new funds to invest that they cannot afford or do not have the time to be too cautious. What follows is that more projects get funded with many being of lower quality, both because of less screening and increased funds flowing to VCs." Since optimists tend to water down or ignore the project screening process, the number of failed projects began to outweigh the number of successful projects.

Once the number of failed projects reached a certain point, there was an immediate impact on entrepreneur optimism. After all, entrepreneur optimism is largely the result of the fraction of funded projects that succeed. A greater number of business failures leads to decreased optimism for would-be entrepreneurs. Moreover, now VC firms had a harder time convincing investor-pessimists to invest. In a classic case, rational agents can convince pessimists to invest by designing contracts that reduce risk and by presenting credible evidence that they screen projects, separating the wheat from the chaff. Once the number of start-up failures escalated, rational agents are no longer able to convince investor-pessimists.

The Coval-Thakor model presents a number of interesting lessons about the VC industry:

  • The single greatest determinant for the level of VC funding appears to be the level of optimism in the economy. Similar to the Goldilocks tale, there needs to be "just the right amount" of optimism. Not enough optimism, and there won't be any demand for new VC funds. Moreover, VC firms will not be able to supply funds at a rate acceptable to entrepreneurs. Too much optimism, and there will be a speculative bubble. At just the right amount of optimism, investor-pessimists are willing to believe that a sufficient number of high-quality projects exist and entrepreneurs are willing to start new projects.

  • The role of VC firms as "cheerleaders" for the technology sector appears to be overstated. What matters is that they have unbiased beliefs, can screen projects, and can design appropriate contracts to attract investor-pessimists. While VC firms devote considerable resources to promoting the Next Big Thing, hype alone does not change entrepreneur expectations.

  • In answering the question: Who is to blame for the VC funding bust? there appears to be a mixed conclusion. Entrepreneurs became too. Moreover, too many entrepreneur-optimists tried their hand at the VC game, leading to a glut of VC investors. According to the Coval-Thakor model, optimists should be entrepreneurs, not financial intermediaries. Thus, two culprits were overly optimistic entrepreneurs that started unrealistic projects and inexperienced, Johnny-come-lately VC firms that funded them. Coval explains, "All participants played a role in the cycle - entrepreneurs could and did raise funds easily and eagerly; VCs could attract many investors and weren't under a lot of pressure to carefully screen their investments; investors with little experience in private equity were attracted by the prospect of high returns and gave funds to VCs with little accompanying oversight."

  • VC firms - as financial intermediaries - exist to screen new projects, design effective contracts that can attract investor-pessimists, and signal to investors that they have the know-how to select positive projects. This would seem to argue for increased due diligence on the behalf of VC investors and the existence of investment agreements that minimize risk for the risk-averse investor-pessimist. Until investors are confident that VC firms will only select the "best" projects, they will demand extra protection.

  • While start-up entrepreneurs complain about the increasing number of tough VC negotiating tactics - the "full ratchet," the "liquidation preference," and "participating preferreds" - these are actually signals that financial intermediaries are working to attract investor-pessimists. Until VC firms can send credible signals to attract these investor-pessimists, there will likely be further stalemate in the VC industry. After all, it is incumbent upon VC firms to form a "beliefs bridge" between the optimists who become entrepreneurs and the pessimists who choose to become investors in financial intermediaries.

So How Do We End the "Beliefs-Trap"?

Since entrepreneurial optimism is the single greatest determinant in the level of VC funding, it makes sense to focus on the one factor that most influences entrepreneur optimism - the level of success of previously funded projects. A recent article in Red Herring magazine makes the interesting case that the fate of the huge number of Internet start-ups funded in the period 1995-2000 (and now on life support or in hibernation) could be a swing factor. If these start-ups are able to survive the technology downturn, it may send a signal to entrepreneurs to become optimistic about their own chances. Other factors may also contribute to greater optimism: a high-profile IPO such as Google; the demonstrated willingness by the venture capital industry to fund "hairy" deals in out-of-favor industries; or the decision by pension funds and endowments to allocate a greater portion of their portfolios to private equity.

Mr. Coval, though, cautions that there are few direct steps that, say, the National Venture Capital Association can take to stimulate a new VC boom: "It's never easy to change expectations - which is the critical factor." Until expectations change, there will continue to be a "beliefs trap" in which further negative signals reinforce one another. Every downward swing of the NASDAQ, then, becomes a type of self-fulfilling prophecy. Without a signal that start-ups are succeeding, entrepreneurs will continue to wait for the big check in the mail.

 

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