TCS Daily

Nothing Ventured

By Dominic Basulto - June 24, 2003 12:00 AM

At a time when the venture capital industry is already reeling from plummeting valuations and negative investment returns, regulatory and accounting changes enacted in response to the corporate governance and accounting scandals of the late 1990s threaten to dampen any remaining incentives for VC firms to finance innovative new ventures. In addition to the Sarbanes-Oxley legislation (originally intended for public companies, but now being extended to private companies as well), there has been increased pressure on institutional investors to provide greater transparency about the financial performance of their VC portfolios. To top it off, the VC community is even splintering when it comes to the issue of whether or not to expense stock options. In mid-June, high-profile VC Vinod Khosla (of Amazon and Netscape fame) of Kleiner Perkins announced that he favored the expensing of stock options. To what extent, though, should the VC industry -- long considered an engine of innovation and economic growth in the U.S. economy -- be subject to the burdensome regulation and bureaucratic oversight of other industries?

If history is any guide (and it usually is), then it is clear that regulatory, tax and accounting changes often spur dramatic changes to the size and scope of the VC industry. Tinkering with stock options, adding new disclosure requirements, forcing private companies to play by the same rules as public companies -- it all seems to smack of a regulatory excess in direct proportion to the "speculative excess" of the Internet era. In December 1995, the Board of Governors of the Federal Reserve System published a comprehensive (and highly durable) analysis ("The economics of the private equity market") of how accounting and regulatory changes have influenced VC investment activity during the 50-year period from 1945-1995. What was truly interesting about the study was that the VC industry has constantly downsized, upsized and super-sized itself over the past 50 years in direct response to regulatory, accounting and tax changes. Moreover, the lag time between implementation and result was, in some cases, less than 12 months.

The VC industry responds positively to an environment that encourages stock options and performance-based compensation. Thus, current plans to force companies to treat employee stock options as an expense could have long-term consequences for the size and development of the American VC industry. Venture capitalists such as John Doerr and Vinod Khosla may differ over exactly how stock options influence economic growth, but one thing is clear: changing the way that technology companies account for stock options will have an impact on the ability of young, untested companies to recruit world-class talent.

According to the Federal Reserve study, the first rapid expansion of the VC industry, which occurred between 1969-1975, only took place after VC firms -- arranging themselves as limited partnerships -- were finally able to offer stock options and performance-based compensation and avoid the shackles of the Investment Company Act of 1940. In addition, other events -- such as a change in the tax treatment of employee stock options in the mid-1970s and the passage of the Incentive Stock Option Law in 1981 -- have also impacted the flow of risk capital into new companies.

Making it harder, not easier, for individuals and institutions to invest in the VC asset class has resulted in sharp spikes in VC activity. The Sarbanes-Oxley legislation, enacted originally for publicly traded companies, could have a chilling effect on the desire of private equity investors to invest in start-up companies. In mid-May, The Deal (the Wasserstein-backed publication for the Wall Street deal community) ran an excellent analysis of how Sarbanes-Oxley could impact the VC industry. The bottom line: Sarbanes-Oxley creates a "messy reality" for private equity firms -- in terms of time and money wasted, nightmare compliance scenarios and a general murkiness about how to align management and investor incentives. The ability to exit an investment, which is the fundamental goal of any VC investor, could also be called into question.

Moreover, recent demands that large institutional investors such as state pension funds divulge the performance of their private equity holdings could have a negative impact on the flow of funds into the VC asset class. Already, CalPERS and UTIMCO have decided to post IRR performance of most, if not all, of the VC funds in which they invest. Some pension funds may decide that it is simply easier to invest in asset classes that are perceived to be "less risky."

According to the Wall Street Journal, there are even more regulatory changes afoot. The SEC investigation into the unregulated hedge fund industry could spill over into the VC industry, creating a challenge to the "accredited investor standard." Raising money for VC funds would become harder, not easier.

Yet, are all these changes really necessary? The VC industry is a marvelously self-regulating mechanism, capable of smoothing out the ebbs and flows without legislative oversight. Two variables -- economic growth and the healthiness of the IPO market -- should be the major factors in adjusting the expectations of VC investors. In good times, VC investors should be willing to invest in risky, early-stage start-ups. While many can fault VC investors for committing imprudent amounts of capital to untested dot-com start-ups during the 1990s, there was nothing inherently unethical, criminal or even unusual about the activity. There may have been some outsized personalities in Silicon Valley and a lot of New Economy hype, but not the deep cynicism and backroom dealing of Wall Street investment bankers like Frank Quattrone. Yet an overreaction to the dot-com bust threatens to replace long-term, strategic thinking about building innovative American start-ups with short-term, tactical thinking about accounting, legal and compliance issues. The result could be the stifling of innovation and the choking off of capital to the technology sector.

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