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Getting Venture Capital Back on Track

Friday, March 30, 2012

How a vital American industry just might make a comeback.

The House and Senate recently passed the Jumpstart Our Business Startups (JOBS) Act, a piece of bipartisan legislation initiated by House Republicans that will help right the U.S. venture capital industry. And they did it in a presidential election year no less!

To grasp the importance of this legislation, you have to be aware of the moribund state of the U.S. venture capital industry. For the past decade, the industry has been in decline. In 2010, the real dollar amount of money the industry raised from its limited partners was 44 percentof 2001 levels; the number of active venture capital funds was 63 percent; and the number deals venture capitalists undertook 73 percent .

The industry’s shrinkage has hindered U.S. economic growth and employment. Venture capital-backed companies produce 21 percent of U.S. GDP and 11 percent of employment in the private sector, despite accounting for less than 0.2 percent of all businesses, according to estimates by IMS Global Insight.

In the world of finance, poor returns lead capital to flow to other asset classes, which it has done with a vengeance.

The industry’s decline comes in large part from its poor financial performance. Cambridge Associates reported that the net ten-year “end-to-end pooled return” to the industry’s limited partners was only 2.6 percent in September 2011. In the world of finance, poor returns lead capital to flow to other asset classes, which it has done with a vengeance. Last year, the industry managed 56 percent of the inflation-adjusted amount it managed in 2001, its peak year.

But the business opportunities being pursued by today’s venture-capital backed startups—companies like Facebook and LinkedIn—are no less attractive than the ones pursued by yesteryear’s startups like Apple and Amazon.com. And today’s investors are no less savvy financiers than the previous generation of partners at venture capital firms. The difference is that today’s venture capital industry faces a regulatory context that makes taking companies public much more difficult and costly than it once was.

Venture capitalists make money when they sell companies they have financed or take them public. Because initial public offering (IPO) valuations have historically been higher than acquisition valuations, IPOs have been the more lucrative exit strategy. But in recent years the IPO market virtually disappeared as an option. In the 1990s, the number of venture capital-backed companies going public as a percentage of the number financed five years earlier—a measure of the industry’s IPO yield—was 18 percent; in the 2000s it was less than 1.5 percent.

Policymakers bear some responsibility for the decline in the number of venture-capital backed companies going public. In response to concerns about fraud at companies like Enron and WorldCom, Congress passed the Sarbanes-Oxley Act (SOX) in 2002, which boosted standards for public company financial disclosure.

Today’s venture capital industry faces a regulatory context that makes taking companies public much more difficult and costly than it once was.

Even though our elected leaders were seeking to combat accounting fraud in much larger businesses than venture-capital backed companies seeking to go public, the latter businesses suffered collateral damage from the regulation. The heavier regulations on public companies in the post-SOX era have increased the cost of going public and complying with federal rules, making venture capital-backed companies less willing to go public.

Fortunately, Democrats and Republicans in both house of Congress have recognized this problem and have begun to fix it. The JOBS Act allows small companies going public a five-year period to “ramp up” to meeting SOX accounting and compliance standards.

By giving young companies the time to meet SOX’s regulatory standards, Congress has made IPOs less onerous for these companies. This change should encourage more venture capital-backed start-ups to go public, enhancing the performance of venture capital firms. That, in turn, should boost capital flows to the venture capital industry and increase investment in high growth new companies, helping them to create jobs and enhance economic growth.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

FURTHER READING: Shane also writes “Equity Crowd Funding: A Good Idea Whose Time Is Now,” “When the Color of Unemployment Is Green,” and “Karl Marx’s Long Shadow in Eastern Europe.” Kevin A. Hassett and Steven J. Davis say “Private Equity Is a Force for Good.” Nick Schulz discusses “Oiling the Innovation Machine.” Mark J. Perry contributes “Unleash Private Sector to Produce Energy, Create Jobs.”

Image by Darren Wamboldt / Bergman Group

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