Why I do this. This was yet another of my attempts to bring academics and practitioners together. I caught the bug on this in the early 1990s, when Stanford hosted a conference on "corporate control," a topic that gained prominence with the rise of takeovers, private equity and leveraged buyouts. All the big names were there: top academics, the chief judge of Delaware's Court of Chancery, the CFO of Merck, and George Roberts of KKR (Kohlberg Kravis Roberts). The chemistry was great, and I got material and inspiration that served me well for many years.
I tried to imitate this model in 1997 with a UC-Davis conference marking the tenth anniversary of the October 1987 stock market crash. At KU I organized a few more conferences along the same lines on various themes: the tumult after 9/11, venture capital and private equity, corporate control in the wake of Enron and WorldCom, and investing in China. In each case I learned a lot, first in picking speakers and topics (harder than you think), and then in the serendipity that comes from smart people exchanging facts and ideas. Worldly wisdom is not going to come knocking on my door. I have to go out and find it, and there's still no substitute for face-to-face interaction.
The Stage. The pieces were in place for my recent event. The Kauffman Foundation provided financial support, including a top-notch venue. We had regional, even national, practitioners on the program, including the head of Angel Capital Association, the founder of Five Elms (a midwest PE/VC firm), and a general partner at MPM Capital (a bioscience venture firm with a national footprint). We were also fortunate to have investment executives from Kauffman's Endowment, which has made substantial investments in private equity/venture capital. And we had the academics, including a clinical professor at Colorado involved both in teaching and ecosystem development.
My Angst. Still, even as a old hound, I had some trepidation. More than just about any area of finance, the gap between what academics know and are interested in, on the one hand, and what practitioners care about seems huge. At that early 1990s conference on private equity in Stanford, there was a revealing and slightly awkward moment when George Roberts gave the after-dinner speech. What role did he see for academics in the private equity revolution? Help to publicize what private equity really is, and explain how it operates and what its effects are. What went missing from that lukewarm endorsement was any thought that the assembled PhD's could ever tell him something he and his very clever associates and advisors didn't know. We were there to throw light and bestow credibility on private equity, perhaps to serve as foot soldiers in public policy and legal battles. But you wouldn't want us doing the deals, not even advising.
What holds for private equity holds for spades in venture capital. The magic sauce in venture capital is the expertise of the venture capitalist. Good venture capitalists know the technology and markets that they are investing in, and they have been in exactly the same spot as the founders of their portfolio companies. What's the role for academics? Not much it would seem. When I first read Venture Deals: Be Smarter than your Lawyer and Venture Capitalist, by Feld and Mendelson, VC's at the Foundry Group in Boulder, I thought, "Why can't professors write like this?" It's compact, to-the-point, and every sentence oozes worldly experience. A thousand years spent poring over the (highly imperfect) data on venture investing is no substitute for a few decades of sweating over deals.
I am sounding pessimistic. There is in fact a role for academics and research. It comes through in the textbook I used in my course (alongside Feld and Mendelson's book): Metrick and Yasuda's Venture Capital and the Finance of Innovation. While it can't match Feld and Mendelson with hands-on-wisdom, its strengths lie in providing a data-based, big picture overview of terms, trends and players in venture capital. Certainly for the limited partner side (say prospective money managers at pension funds, endowments and family offices), there's value here that a venture capitalist cannot provide. (Now there's also a downside to the academic's insistence on rigor, consistency and a tight disciplinary lens, but that's a topic for later.)
Much to my relief, the role of academics also came through at our recent conference, to which I now turn.
Light Emitted from an Imploding Law Firm. For my taste, the academic paper that threw the most light on the conference theme of early stage investing was "Does Angel Participation Matter? An Analysis of Early Venture Financing", presented by Gerard Hoberg and written with three of his colleagues at the University of Maryland. The short version: a big-name law firm (Brobeck Phleger Harrison) goes bust, and its records are turned into a research archive, allowing Hoberg and his colleagues to look at how both venture capital and angels participate in early stage investments. This is almost never ever possible because while there are commercial databases that do a so-so job of tracking venture investments, angel investments are tracked by no one, despite the fact that angel investments account for a large proportion, perhaps more than half of early stage funding. Whatever pops up in this rare database will be news. It turns out that most of the first rounds in the sample had mixed VC-angel funding. (Who knew? Perhaps very experienced investors, but not this professor.) Much has been written about VC-angel conflict in startups, which sets the stage for the paper's most intriguing result: exit outcomes are worse not if a company has both VC's and angels investing, but rather if the board is split between the two investor types. Now that's something worth pondering.
The Venture Capital Model Is Broken. One theme I should have known was going to bubble up, but didn't figure largely in my expectations was the refrain, "the venture capital model is broken". The symptom is well known: essentially zero net return to limited partners for over a decade. The possible causes are not, at least when I speak from the standpoint of the stylized facts and received wisdom on the academic side. One force that receives some attention, and that was highlighted by Kauffman's Harold Bradley, is too much money flowing in, annual flows still well in excess of what came in during the early 1990s. I think academics have a hard time with this because it relies on the notion of "dumb money" and thus irrational or poorly informed investors. The other force is incentives, and the emphasis on misalignment of incentives was something new for me. I have certainly seen enough academic and industry coverage to know that the 2-and-20 rule (2% management fee plus 20% "carried interest" or share of upside going to the venture capital firm) is often revered as a stroke of genius that "aligns incentives". (The standard academic criticism is that it encourages VC risk taking, based on the similarity of the payoff profile to a long call option.) Yet, that formula came in for some hard knocks, as did the sketchy transparency offered by some venture firms to limited partners. (I say "some" because practice no doubt varies.) At the risk of imputing even more complacency to others than I was guilty of, I think scales fell from some eyes. Thanks go to Harold and his colleagues Diane Mulcahy and Thom Ruhe for ending the day on an important and thought-provoking note.
Early Stage Venture Investing: Sources, Terms and Trends Friday, March 30, 2012 Kauffman Foundation, Kansas City, Missouri
Organized by George Bittlingmayer, School of Business, University of Kansas, and made possible with the support of the Kauffman Foundation
7:30 – 8:00 am – Breakfast 8:00 – 9:30 am – Panel Presentations and Discussion
o Fred Coulson, Five Elms Capital
o Steven St. Peter, MPM Capital
o Marianne Hudson, Angel Capital Association
o Brad Bernthal, Silicon Flatirons Center
Moderator: Matthew McClorey, Bioscience and Technology Business Center
9:30 – 9:50 Break
9:50 am – 11:50 am - Research Presentations
o Ola Bengtsson, University of Illinois, “Different Problem, Same Solution:
Contract-Specialization in Venture Capital” Discussant: Jide Wintoki,
University of Kansas
o Susan Chaplinsky, University of Virginia, “Exit Returns and Venture
Capital Investment Opportunities” Discussant: Felix Meschke, University of
Kansas
o Thomas Chemmanur, Boston College & MIT, "Venture Capitalists versus
Angels: The Dynamics of Private Firm Financing Contracts" 12:00 – 1:00 pm - Luncheon Presentation – “Teaching Early Stage Investing,” Brad Bernthal, Silicon Flatirons Center
1:00 – 3:00 pm – Research Presentations
o Gerard Hoberg, University of Maryland, “Does Angel Participation Matter? An Analysis of Early Venture Financing” Discussant: Brad Bernthal
o Brian Broughman, Indiana University, “Do VC’s Use Inside Rounds to
Dilute Founders? Some Evidence from Silicon Valley” Discussant: Na Dai,
SUNY Albany
o Harold Bradley, Diane Mulcahy and Thom Ruhe, Kauffman Foundation,
“A Discussion: The Breakdown in Alignment Between Entrepreneurs, Investors and General Partners in Private Finance"
