A Venture Capital History Perspective From Jack Tankersley

In January, Jerry Neumann wrote a long and detailed analysis of his view of the VC industry in the 1980’s titled Heat Death:  Venture Capital in the 1980’s. While I don’t know Jerry very well, I like him and thought his post was extremely detailed and thoughtful. However, there were some things in it that didn’t ring true for me.

I sent out a few emails to mentors of mine who had been VCs in the 1980s. As I waited for reactions, I saw Jerry’s post get widely read and passed around. Many people used it as justification for stuff and there were very few critical responses that dug deeper on the history.

Jack Tankersley, a long time mentor of mine, co-founder of Centennial Funds, and co-founder of Meritage Funds, wrote me a very long response. I decided to sit on it for a while and continue to ponder the history of VC in the 1980’s and the current era we are experiencing to see if anything new appeared after Jerry’s post.

There hasn’t been much so after some back and forth and editing with Jack, following is his reaction to Jerry’s piece along with some additional thoughts to chew on.

It is good that Mr. Neumann begins his piece in the 70’s, as that era certainly set the table for the 1980’s. You may recall I got into the industry in 1978.

The key reason for the explosion in capital flowing into the industry, and therefore the large increase in practitioners, had nothing to do with 1970’s performance, early stage investing, or technology. Instead, it was the result of two profound regulatory changes, the 1978 Steiger Amendment, which lowered the capital gains tax from 49% to 28%, and the 1978 clarification under ERISA that venture capital investments came within the “prudent man” doctrine. Without these changes, the 1980’s from a venture perspective would not have happened and the industry would have remained a backwater until comparable regulation changes stimulating capital formation were made.

Secondly, the driver of returns for the funds raised in 1978 – 1981 was not their underlying portfolios, at what stage, or in what industries they were built. Instead, the driver was the 1983 bull market. The Four Horsemen (LF Rothschild, Unterberg Tobin, Alex Brown, H&Q and Robinson Stephens) basically were able to take any and everything public. Put a willing and forgiving exit market following any investment period and you get spectacular returns.

So contrary to the piece, it wasn’t VC were good at early stage technology, it was that they had newfound capital and a big exit window. For example, my firm at the time, Continental Illinois Venture Corporation, the wholly owned SBIC of Chicago’s Continental Bank, had many successful investments. Some were Silicon Valley early stage companies, such as Apple, Quantum, and Masstor Systems.  I handled CIVC’s investments in the latter two (in fact, I also “monitored” Apple as well).  Take a look at the founding syndicates of each:

Masstor Sytems (5/1979)     Quantum Corporation (6/1980)
CIVC $   250,000     CIVC $   200,000
Mayfield II $   250,000     Sutter Hill $   790,000
Continental Capital* $   250,000     KPC&B II $   775,000
Genstar** $   275,000     SBE+ $   700,000
S & S*** $   225,000     Mayfield III $   500,000
    BJ Cassin $     75,000
Total $1,250,000     Total $3,040,000

*Highly regarded private SBIC, **Sutter Hill Affiliate, ***Norwegian Shipping Family, +B of A’s SBIC

What is striking about these syndicates is that nobody had any meaningful capital, which forced syndication and cooperation.  CIVC’s only “competitive” advantage was its ability to write a check up to $1 million. In this era, the leading VC firms such as Mayfield, Kleiner, and Sutter Hill (all shown above), rarely invested more than $1 million per company.

When we syndicated the purchase of the Buffalo, New York cable system, we literally called everybody we knew and raised an unprecedented $16 million, a breathtaking sum in 1980. As dollars flowed into the industry, cooperation was replaced by competition, to the detriment of deal flow, due diligence, ability to add value and, of course, returns.

CIVC had a number of highly successful non-technology investments made in the late 1970’s timeframe, such as:

  • LB Foster: Repurposed old train tracks
  • JD Robinson Jewelers: The original “diamond man” (Tom Shane’s inspiration)
  • National Demographics: Mailing Lists
  • American Home Video: Video Stores
  • Michigan Cottage Cheese: Yoplait Yogurt
  • The Aviation Group: Expedited small package delivery
  • JMB Realty: Real Estate Management company

None of these companies fit Mr. Neumann’s definition of the era’s venture deals and each generated returns we would welcome today.

For many years preceding 1999, the 1982 vintage was known as the industry’s worst vintage year.  Was this a function of “too much money chasing too few deals” as many pundits claimed? Not really; it was a result of an industry investing into a frothy market at higher and higher valuations in expectation of near term liquidity, and suddenly the IPO window shutting, leading to no exits and little additional capital to support these companies.

Mr. Neumann’s post also misses the idea that it was a period of experimentation for the industry, This time period saw the rise of the industry-focused funds and the advent of the regional funds. Many of the industry funds were wildly successful (in sectors such as media communications, health care, consumer, etc.), while none of the non-Silicon Valley regional firms were long-term successful as regional firms. Some regional firms, such as Austin Ventures (in Austin, TX) did prosper because they subsequently adopted either an industry or national focus. The remainder failed as a result of the phenomenon of investing in the best deals in their region which typically were not competitive on a national or global scale. Just imagine doing Colorado’s best medical device deal which was only the 12th best in its sector in the world.

Some additional observations include:

  • Many of those quoted in the article such as Charlie Lea, Kevin Landry, Ken Rind, and Fred Adler, were all very well known in the industry. However, none were based in the Silicon Valley and are probably unfamiliar names to today’s practitioners. I knew them all, because we all knew each other in this era.
  • “By January 1984, investors had turned away from hardware toward software.”  This isn’t true. Exabyte, one of Colorado’s hottest deals, was formed in 1985; Connor Peripherals (fastest growing company in the history of technology manufacturing, four years to $1 billion in revenue) raised its first round in 1987.
  • “By 1994 the big software wins of the 1980’s were already funded or public.” This isn’t correct either. A good example is Symantec
  • “Ben Rosen, arguably the best VC of the era”. While Ben may well have been among the best, in the early 1980’s Ben was brand new to the industry. He was a former Wall Street analyst with no operating or investment experience, who became a VC by teaming up with operator LJ Sevin. Even many newcomers with little real experience were quite successful.
  • Silicon Valley firms also did many non-tech deals. Sequoia followed Nolen Bushnell from Atari into Pizza Time Theaters (and according to legend, did well). I well remember being in Don Valentine’s office as he waxed poetically about his new deal, Malibu Race Track. Unfortunately Reed Dennis of IVP did not do as well in his Fargo, ND-based Steiger Tractor investment!
  • “Venture capitalists’ job is to invest in risky projects.”  This statement is scary to me. We should be risk evaluators, not risk takers.  We should invest where our background and instincts and due diligence convince us the anticipated return will far exceed our evaluation of the risk. There are five key risks in any deal:  Market, Product (a/k/a technology), Management, Business Model, and Capital. Taking all five at once is crazy. Most losses happen when you combine Market and Product risk – take one, not both, and take it with a proven entrepreneur.
  • “The fatal flaw of the 80’s was fear”. I strongly disagree. Instead, it was the result of virtually no liquidity windows after 1983. As mentioned, the industry also experimented with new strategies such as industry focus funds and regional focus funds. Some worked; some did not.  Also in the 80’s, the megafunds were created (at the time defined as $100 million plus); the LBO sector outperformed venture through financial engineering; asset gatherers, such as Blackstone, were created. The biggest Wall Street crash since the Great Depression (October, 1987) shocked us all.  “They don’t talk about the 80’s”; if true, maybe it’s because the period cannot be simplified.

The 1980’s proved there is more than one way to “skin a cat”. Early stage technology may be one; but it is not the only one and may not be the best one, then or now. My advice to a venture capitalist, then, now or later, is simple:  Do what you know, do what you love; build great companies and over time you will succeed.

  • Jo T.

    Wow, much to ponder. A great set of observations.

    • I find it extremely useful to have at least a once a year dinner with Jack. I have a few other “old times” like Steve Halstedt (who co-founded Centennial Funds with Jack – I think in 1983) who I try to have a long dinner with at least once a year. It grounds me immensely.

      My only regret from not still living in Boston is that I don’t have an easy way to do the same with Paul Maeder and Bill Kaiser.

  • Sam

    Thanks much for linking to Jerry’s original and posting Jack’s observations. Great stuff throughout, and a lot to think about.

    I do believe there remains a central question around whether we have “too much money chasing too few deals” today and, if so, what incentives that creates for actors on the VC side.

    “Too much money” is a function of the capital markets. Interest rates, alternative investment classes and expected rates of return, capital markets regulatory.

    “Number of deals” a function fundamentally of technology. Cost to develop and put a product in market. Size of the market that can receive that new product. Maybe some regulatory variables around what is allowed on the health care side.

    There’s a complex equation linking the two, and ideally you’d have the amount of VC money perfectly matching up 1:1 with the amount of “VC-worthy” deals that require it. But there’s nothing that says the two have to be in equilibrium. In fact, given the different nature of the variables on either side of the equation, I think we have to assume we rarely are at equilibrium in the aggregate.

    So in the absence of that, VCs individually go where they think they can get the returns. They wander into new industries, new asset classes, new stages of investment. Makes sense if they have skills in those areas. But rarely do you hear a partnership say, “You know what? There’s just too much money out there chasing too few deals. We can really only put this much to work effectively in the current environment, and we’re going to maintain disciplined focus on our investment thesis, because we know that really well.”

    One of the things I admire about Foundry Group is that you cap your fund so that you can do exactly that.

    • Well said.

      There will always be a supply / demand imbalance. It’s part of the dynamic, especially given how quickly money moves in and out of segments when it is seeking returns. In the case of VC, the fund structure for most firms (10 years with a 5 year investment period) slows down the velocity in both directions, which probably makes things worse short term but better long term.

  • I really miss Alex Brown, H&Q, and Robinson Stephens. They all had great conferences and were so fun to invest with.

    • And they knew how to get companies public!

      • Yes they did. I remember making lots of money with companies that were considered quaint at $100mm valuations. Aspen Technology, Wonderware, Snap Servers, etc.

  • I liked the five key risks in any deal: Market, Product (a/k/a technology), Management, Business Model, and Capital.
    Actually, I like it a lot.
    They are related to success, although not so visibly intertwined at the beginning.

    • Jack taught me that VERY early on – I think we discussed it in one of our very first meetings.

    • Those five risk areas are the same our businesses uses.

      (We look for evidence from e-treps demonstrating that they have: sufficient customer relationships [market risk], a proven product, the right team, and an appropriate business model. We don’t measure access to the appropriate capital, but clearly identify that as a necessary component for e-ship success.)

      I’m happy to see Jack (and Brad and you, William) echo those here.

      Is it possible that there is a better taxonomy for those risks? Might there be a 6th or 7th bucket? If so, what would it be?

      I ask to test what seems to be a thoughtful and long-standing theory. I suspect it would stand up to harsh scrutiny, but would love to see someone try to poke holes.

    • Oh and, William, to your point: “They are related to success, although not so visibly intertwined at the beginning.”

      We draw a flow chart pointed toward company growth and wealth creation. All 5 risk buckets live below an AND junction through which the e-trep must pass to build a successful company.

      While I agree that this phenomenon is hidden from many (especially less experienced e-treps) it is nevertheless there. I believe that this framework is a crucially important concept for e-treps to understand because we see that AND junction as a very real gate. A successful company cannot be achieved without mitigating all 5 families of risk. Of course, the clock is ticking and one must more or less solve for all 5 at once…

      This is one of the many reasons building a successful business is so difficult.

    • Here’s the flow chart.

    • Oh and, William, to your point: “They are related to success, although not so visibly intertwined at the beginning.”

      We draw a flow chart pointed toward company growth and wealth creation. All 5 risk buckets live below an AND junction through which the e-trep must pass to build a successful company.

      While I agree that this phenomenon is hidden from many (especially less experienced e-treps) it is nevertheless there. I believe that this framework is a crucially important concept for e-treps to understand because we see that AND junction as a very real gate. A successful company cannot be achieved without mitigating all 5 families of risk. Of course, the clock is ticking and one must more or less solve for all 5 at once…

      This is one of the many reasons building a successful business is so difficult.

  • Fabulous post. Thanks.

  • bradbernthal

    This post’s timing syncs with kick off of our Venture Capital class at CU-Boulder. Perfect. Three observations:

    1. Jack is modest in the above analysis when he writes about the early 80s:
    “As mentioned, the industry also experimented with new strategies such as industry focus funds and regional focus funds. Some worked; some did not.” He could have mentioned that Centennial started in 1981. Jack left in 1997. Steve Halstedt, Jack, and the Centennial team returned positive funds to LPs every time from its initial 1981 fund through the end of the 90s. (Jack or Steve can fact check this.) They put together one of the great runs in VC history.

    2. The importance of the Prudent Man Amendment (signed in 1979, I believe) and the 1978 capital gains reform in unleashing venture capital in the 1980s is – from an academic perspective – correct. VC investing in 1980 was a little over $500 million in the United States. By 1983 it is $3 billion. Those numbers hold throughout the 80’s. Most academic accounts credit the late 70s policies for helping unlock capital to the VC sector.

    3. The importance of the Prudent Man Amendment and the capital gains reform underscores that, for entrepreneurs and innovation, politics and background laws matter. We generally just complain about policy errors. But getting it right deserves a hat tip, too.

    Brad

    • On 2, I agree that the change in ERISA brought on the flood of money in the 80s (Jack and I actually agree on most of his points; as I said in the post: “Money had been pouring into venture capital since a 1978 change in regulations allowed pension funds to consider it a ‘prudent’ investment.”), but I don’t believe the change in capital gains tax accounts for the increase in VC funds. The academic literature takes both sides, the literature closer to the event giving it more credit than later literature. My thoughts:

      1. Subsequent changes in the capital gains tax rate do not seem to have had any effect on the amount of money going into VC.

      2. Regional variations in cap gains tax rates also seem to have no effect. The highest capital gains rates in the country, when you take state taxes into effect, are in California and New York, where the VC industry flourishes, and the lowest are in Puerto Rico (no federal or state cap gains tax) and a few states with no state cap gains tax, of which only Texas has an appreciable VC industry.

      3. VCs are generally pass-through tax entities (ie. partnerships in the tax sense) and the bulk of the money in VC funds is from non-taxed investors (pensions, universities, etc.) so the capital gains rate is simply immaterial to them.

      I’m not sure what argument can really be made for the change in tax law being a driver of VC funds, other than the coincidence in time. And the coincidence in time is vastly overshadowed by the change in ERISA. China is running an enormous natural experiment right now, of course, by allowing its pension funds to invest in their stock market. It will be interesting to watch.

  • myBestHelper

    It’s amazing how much knowledge has been hard earned and yet is still not accessible, either because it’s too sensitive to publish or simply because it’s not in a format that can be widely shared. That said – being an entrepreneur today gives you access to unprecedented wealth of information, and all from the comfort of your own screen. Shocking how some of the most amazing video interviews with entrepreneurs get so few views on Youtube. Thank you for sharing what Jack wrote, most interesting. (Alexandra T. Greenhill, cofounder CEO http://www.mybesthelper.com

  • tim logie

    What I find most interesting is that you bring up the lack of a liquidity window in 1983 as an important issue. This drives home that fact that everyone needs to understand the whole ecosystem from start to finish (with the finish being the exit).
    Many others (not your readers!) think that Venture Capital is on an island, insulated from the public markets but the reality is that Venture Capitalists need the public markets to be open or a) companies can’t raise cash to purchase other companies or b) companies can’t go public or raise debt and provide the exit that Venture Capitalists need.
    Thanks for bringing that up, I think that is super powerful in helping understand the environment we are in and the issues in front of everyone.

  • Another big development was Senator Robert Dole and Senator Birch Bayh efforts on university intellectual property. http://www.univsenate.pitt.edu/sites/default/files/OTM-Bayh-Dole%20Act.pdf Passed in 1980, it allowed commercialization that wasn’t easy to do before.

    We can learn from history. Certainly there are plenty of roadblocks that need to be cleared in the federal regulatory ledger that would be a big boon to venture capital and innovation. I’d love to see taxes lowered, and tax credits given for risky investments. They need to renew the law on zero taxes at the federal and state level for seed stage investments in companies worth less than $5M and held 5 years or more if they haven’t already.