But with crisis comes opportunity, which is why policymakers in Washington need to enact several key reforms to help capital market formation work more efficiently for startup companies looking for money to grow our nation’s stock of innovation and create new and more abundant jobs. Fortunately, President Obama agrees that the science-and-technology economy in our country is the foundation of our prosperity and deserves a good deal more nurturing than has been the case in the past.

Here’s one obvious example of the importance of fostering venture capital-backed company successes and the resulting impact on our economy: In 1990 Microsoft Corp., Dell Computers Inc., and Cisco Systems Inc. had combined sales of $2 billion, but ten years later their combined sales were $80 billion. These and other technology behemoths began as venture capital-backed startups, and the same is true today for the next generation of Microsofts, Dells, and Ciscos.

The tech economy is supported on the shoulders of the venture capital sector, which I have labeled, for purposes of abbreviation, the EVITA sector, or Entrepreneurial Venture-backed, Innovation-centric, Technology-flavored Activity, which provides critical sustenance for companies founded by gifted entrepreneurs and aimed at the financing journey from the “embryo to the IPO,” exploiting innovative intellectual property, including business methods, to change our lives for the better. I mention the “embryo to the IPO” because this is where capital markets regulatory reform comes into the picture. Reopening the IPO window is critical, in my view, to keeping the tech economy, and accordingly the economy of this country, on a solid and robust growth path.

Next, we need to unlock even more private capital to fund early-stage startups. Today we are leaving billions of dollars of potential gross domestic product growth stranded in the wilderness because seed money for promising EVITA companies sits on the sidelines. As a paper by two of my students at New York University notes:[1]

The economic impact of the seed money gap is staggering. At a conservative minimum, at least $4 billion is lost to the United States economy each year. More realistically, the economy losses closer to $100 billion per year because of the funding gap. Socially, the losses are just as great. Products and services that would improve the lives of countless people are either never developed, or significantly delayed.

The answer to our broken IPO financing pipeline and our moribund seed-stage venture financing landscape lies in a series of regulatory reforms that are admittedly arcane for non-financial types but nonetheless crucial to the future of our economy. Below are my (sometimes controversial) suggestions to rebuild our IPO markets and re-engage seed stage investors in the creation of new, competitive companies and industries across our country.

Sarbanes-Oxley Reform

This is perhaps the second-most controversial reform suggestion I will make. The costs of complying with the financial reporting requirements of the Sarbanes-Oxley Act by public companies are overblown by some critics, and the expenses of complying with these reporting requirements are slowly coming down. Nonetheless, to help young high-tech companies tap the public markets for new capital, policymakers need to undertake a bottom-up review of the regulatory burdens on both public and private business firms, including but by no means limited to Sarbanes-Oxley.

Given the way government works, mandates to the agencies themselves to reduce unnecessary paperwork, make-work tasks, unnecessary reviews and endless waiting periods is, typically, fruitless. The classic solution is an end run—an independent study group manned by the neutral and knowledgeable—to cut through the sludge, hold hearings, and render detailed recommendations for reducing wasted effort and pointless expense.

The core idea is to eliminate frictional costs without sacrificing hard-won transparency. Audit fees of $1 million are an enormous burden for a venture-backed IPO candidate to contemplate. In my view, a report by the knowledgeable commission I suggest, including representatives of emancipated audit firms that are already moving in the direction of lowering unnecessary costs, is a critical need.

IPO Market Reforms

The first element needed to bring back the IPO is a liberalization of the rules governing IPO market processes, entailing what I call the “long runway,” or a system for allowing the marketplace to review IPO candidates in a leisurely way.[2] We need to remove the hysteria, resembling nothing so much as the opening weekend of a Hollywood movie, from the current process. There has been a little progress in this regard, but much more needs to be done.

In addition, we need to restore, under the appropriate guidelines and rules, the role of the sell-side analysts who do the investor research on these small companies after they go public so that the shares of newly-listed small- and mid-cap companies can tell their story to institutional investors on an on-going basis. This is very hard today because institutional “buy side” interest in smaller public companies disappears when analytical coverage is AWOL.

In fact, for a public company, lack of research coverage by the major investment banks, including the members of the underwriting syndicate, means a berth in the so-called “orphanage,” with stock prices trailing off and liquidity diminished to the “trading by appointment” level. This lack of research coverage—the result, in my opinion, of over-reaction to the dotcom IPO scandals of the late 1990s—is now the reason startup companies face such long odds going public, and then surviving and growing as public entities the way Microsoft, Dell, and Cisco did two decades ago.

I agree with former investment banker (and poster child for the dotcom feeding frenzy) Frank Quattrone, who proposes that our federal regulatory agencies—prodded if necessary by a commission such as the one I have hypothesized—focus on and adopt tried-and-true steps to restore the integrity and objectivity of the sell-side analysts but allow them to be paid on the basis of merit. The core idea is to wall off the Goldman Sachs Group Inc. analysts from the Goldman investment bankers and salespeople, but to allow the analysts to be paid the going rate out of corporate finance revenues. This pay structure must insure that compensation is not tied to the amount of such revenues and that base pay and bonuses are administered by a compensation committee of independent directors, advised by independent counsel and consultants, who will make sure an analyst cannot be fired for trashing Goldman-backed IPOs and M&A valuations.

Executive Compensation

Tying the compensation of corporate managers to the performance of the company shares, thereby aligning management and ownership, was a 1980’s “reform” driven by investors activists and their media acolytes, but which was instituted only half way. To complete the process, I urge we introduce a tax efficient structure entailing a ten-year time horizon for judging the effectiveness of executive compensation alongside a clawback provision governing that compensation so that any bonuses judged unworthy over 10 years can be reclaimed by shareholders. This provision should mirror the compensation arrangements for company executives with compensation arrangements for the managers of private equity funds with investment time horizons of ten years.[3]

In fact, as far back as 2004, I suggested the clawback mechanism, in an interview with Broc Romanek in Corporate Executive’s online edition.[4] In the wake of today’s financial crisis, this kind of reform is more urgent than ever, and would benefit investors in high-flying IPO offerings that, over time, may come crashing back to earth—as happened at the end of the dotcom bubble. These kind of compensation rules would ensure that executives keep their eye on the long-run performance of their companies.

Tax Reform

One of the more troubling tax reforms proposed by the Obama administration is to tax the so called “carried interest,” or the percentage of the profits earned by the managers of private equity funds, hedge funds, and venture capital funds alike for investing in successful companies. Rewarding venture capitalists for taking investment risks alongside institutional investors in their funds is a critical element of a successful EVITA sector. Taxing the carried interest at ordinary income rates would be major step backwards for these venture firms, and will not raise significant revenue.

The real unjust enrichment problem is with management fees charged by the big hedge funds, private equity funds and a few large VC funds. These fees go way over-the-top and are tied only to the size of the fund and not to performance. Reintroducing the idea of budgeted management fees is the right reform in this regard.[5]

Conversely, the negative influence of fast buck artists—including hedge funds and other so called “activist investors”—on the fortunes of public companies is increasingly clear. The case against the activists, who are in my view the equivalent of casino capitalists, is eloquently expressed in a piece by Marty Lipton, who argues that the activists trumpeting “shareholder democracy” and their academic and media acolytes are making it difficult for corporate boards to function in the long-term best interests of the company, the employees, patient investors … and, in fact, the country.[6]

Marty’s concerns are spot on, in my view. Indeed, the latest meltdown is just the latest indication of what happens when the stewards of major public institutions are obsessed with instant gains that appear too good to be true and typically are too good to be true. Our financial system should be built to secure long-term, sustainable growth in the private sector. Accordingly, I suggest that taxes on securities transactions should be adjusted so that, if new capital-gains taxes are on the launching pad, then gains on long-term investments should be taxed at a significantly lower rate than short-term gains.

A lower tax on patient capital, say the sale of shares held for five years, is the way to go. We need to reward patient investors so that public companies can pursue long-term goals, including research and development and innovation. Our economy gets no positive impetus when S&P 500 companies must pander to day traders by buying back stock, dissipating working capital in the form of special dividends, eliminating critical long-term capital expenditures, and auctioning the company to a (seemingly) higher bidder.

Restoring Risk Capital to its Rightful Place in Venture Financing

Perhaps the largest need at the moment, assuming we can re-open the IPO window and make public company status again desirable and a realistic goal of venture capital activity, is to rehabilitate angel investor financing. As Silicon Valley entrepreneur Michael Malone and ABC.com columnist Tom Hayes put it recently in a Wall Street Journal column titled “Entrepreneurs Can Lead Us Out of the Crisis:”

The marquee venture capitalists have little time nor inclination anymore to invest seed capital in early stage companies. The real heroes these days are the nonprofessional investors, the “Angels.” These folks aren’t always the high-net-worth people we imagine, and often they aren’t as sophisticated as we think.

Angel investors, who put their own funds into early stage start-up ventures, have been badly burned in today’s financial markets (as has everybody else), which means the quest for risk capital among startup companies, regardless of how attractive the proposition, is becoming consuming to the point that the search is in many cases simply not realistic. We need to bring back the angels because, without them, the venture process never gets started.

One place to start is at the Small Business Administration. Thus we ought to take a look at the so-called preferred securities program, which authorized the SBA to fund venture capital partnerships which qualified as Small Business Investment Companies, or SBICs, by making equity capital (versus loans) available to those groups. This program tanked because the SBA’s participation was limited on the upside and unlimited on the downside, a “heads you win tails I lose” proposition which, after the dotcom meltdown, deserved to be thrown under the bus, as indeed it was.

That does not mean, however, that the program could not be brought back to life, but restructured so that the risk/reward formula for the SBA and the taxpayers is configured to give the government a level playing field with private capital. Furthermore, the benefits should accrue to venture capital funds focused on early stage ventures, funding the gap between the friends and family round and the late stage mezzanine round … and certainly not including buyout funds that dominated the earlier program.

The second project, which does not require the commitment of taxpayer capital, is to pull together, in one online data source, a directory of as many angel investor clubs as can be located—all for the convenience of entrepreneurs seeking angel capital. The list need not be confined to groups specifically labeling and identifying themselves as “angel clubs” or “groups” because there are a variety of entities that fulfill the same function, including online matching services such as

• SBA-sponsored Active Capital business plan competitions
• Venture capital clubs as they are often styled
• University-sponsored colloquia such as the MIT Enterprise Forum
• Events sponsored by investment banks and other commercial sponsors at which private companies present their business models.

To make such an information platform attractive and useful, however, one additional step could usefully be taken—a Zagat-type inquiry directed to each organization seeking critical information for both angels and other investors, including the “track record” of the organization. The information provided in the directory should include:

• How many investments has it made
• How many members does it have
• The total amount invested in companies presenting
• Average investment size
• Investments made as a percentage of investment proposals presented.

Further, the survey should collect the equivalent of restaurant reviews of the angel group from previous users (tossing out rants from the obviously disgruntled) so that applicants for capital can make up their own mind whether to zero in on that particular group.

And, on the tax front, we need a tax efficient structure by which angels and founders can mitigate the impact of dilution occasioned by subsequent venture capital financings, which is often very hard on the early money. I am plugging hard for what I call “up-the-ladder warrants,” which would enable early investors in young companies to participate fully when the company eventually goes public or is sold through warrants that will make up for the dilution the angels encounter in follow-on rounds of venture financing.[7]

The exercise price of the warrants would be set at a number that is well out of the money (hence the name “up the ladder”), keeping the VCs content to leave the warrants in place when they invest. Assuming all goes well with the sale or public offering of a startup invested in by angels and VCs, both types of investors can profit from their different types of investments in the startup company. To make this structure compelling for angels, I suggest the gain on the warrants should be treated as taxable under Internal Revenue Code Section 1202, which reduces by half the tax on the gain from the sale of securities issued by Qualified Small Businesses (as defined in the Code), assuming that the investment has been held for five years.

Specific Securities Law Changes

I suggest as well that the SEC finally get off the dime and expressly refashion the bar in the Securities and Exchange Commission’s Regulation D against “general solicitation” and “general advertising” in connection with the search for private capital so that it fits current, fully legitimate business practices in the private placement arena. The bar against soliciting or advertising for private capital is meant to separate private and public offerings in order to protect investors, but it is viewed in the industry as an anachronism and is seldom enforced.

An update is long overdue. The rules should be reconfigured so that whatever regulation is appropriate is in fact the regulation that exists on the books. Widespread (and unofficially countenanced) disregard of a major securities rule is not consistent with best practices or healthy for securities regulation generally.

The same holds true for the question of unregistered finders or those individuals and firms who limit their investment banking functions to helping startups (and other private firms) find private capital.[8] The passage of a so called “broker/dealer lite” amendment to Reg D is long overdue. We should legitimize “finders” who do not have any other attributes of investment banks or broker/dealers as they help entrepreneurs find capital, and regulate them at prices they can afford.

Finally, I would also like to see full legitimacy afforded, with the appropriate oversight, to private trading platforms such as SecondMarket, which will allow trading among sophisticated investors in private securities, thereby affording liquidity to investors in venture-backed companies when circumstances change and cash is needed, either by the limited partners in a venture fund or investors directly in a startup company. SEC regulation of the platform is, of course, desirable. (Full disclosure: SecondMarket has an alliance with VC Experts, of which I am a senior contributing editor.)

Capital Markets Reform is Key

Private capital formation in support of innovation is the province of the private sector, as it should be and should remain. But the federal government, as it goes about its vital financial regulatory work, fiscal responsibilities, and economic development efforts in support of broad-based economic growth and prosperity, needs to take into account how all of these efforts affect private capital formation. In my view, the regulatory reforms, market oversight reforms, executive compensation reforms and securities law reforms outlined in this column are the best places to start. Our nation’s capacity to innovate our way out of the current recession and boost our long-term global economic competitiveness hangs in the balance.

Joseph W. Bartlett, an advisory board member of Science Progress, is Of Counsel at Sullivan & Worcester LLP, a courtesy professor at the Johnson School of Business, Cornell University, and founder & chairman, VC Experts, Inc.

Endnotes

[1] www.vcexperts.com, “An Initial Measurement of the Impact of the Seed Money Gap on the U.S. Economy,” Section 13.1.3, The Encyclopedia of Private Equity and Venture Capital

[2] http://www.joebartlettvc.com/sites/default/files/Bartlett_Shulman.pdf

[3] http://www.joebartlettvc.com/sites/default/files/gzp4n01_.DOC_.pdf

[4] This interview originally appeared in the online version of The Corporate Counsel and the thoughts expressed therein repeated and re-emphasized in Bartlett & Lundburg, “A New Executive Compensation Model,” NYLJ, May 16, 2007.

[5] See e.g., Kreutzer, “Putting The ‘Partner’ Back in Limited Partner,” Private Equity Analyst Plus, 4/9/2009.

[6] http://blogs.law.harvard.edu/corpgov/files/2007/02/20070210%20Lipton%20Address.pdf

[7] http://vcexperts.com/vce/news/buzz/archive_view.asp?print=true&id=109

[8] http://www.joebartlettvc.com/sites/default/files/Document.pdf

Initial Public Offerings historically have been a pillar of U.S. venture capital.

What’s more, private stock sales are advantaged by the safe harbor in Regulation D, whereby young companies can access capital from accredited investors who are deemed sufficiently sophisticated by regulators to understand the risk of investing in high-risk, high-reward private equity. This means young entrepreneurs and their private capital backers have legal, although limited, access to the vast pools of alternative-investment players in U.S. and global capital markets.

There is, however, room for significant improvement in our federal securities laws to help young and promising—though still very risky—emerging growth companies tap the public markets for funds to fully commercialize their products and services. Why? Because Initial Public Offerings historically have been a pillar of U.S. venture capital. An open and liquid public market receptive to high tech companies in relatively early stages of their development allows entrepreneurs and their VC backers to construct their pricing models and to value their portfolios.

This is critical because the use of IPOs in standard portfolio-pricing models invigorates the private investment process up and down the line. IPOs justify a portfolio of risky investments on the theory that, if some percentage turn out to be “portfolio makers” as a result of an IPO “exit,” in which the venture capital investors are able to sell their equity in a startup at many times the amount they initially invested, then the VCs can take risks they would not otherwise be in a position to take if company sale were the only way to monetize their investments. The IPO is the rising tide which lifts all boats.

Moreover, IPOs add to the choice of available public securities for investors to review and allow venture-backed companies to grow as independents—think Microsoft, Yahoo, Google, Amgen—and not a division of IBM, Time Warner, or Pfizer. Without venture capital backing, Apple Computer, Intel, Yahoo, Amazon.com, and e-Bay would be ideas, and not mega-corporations.

Problems in the IPO Marketplace

The IPO market comes and goes, of course. But, so far at least, even though it shuts down every now and then, it has always returned. This time, we are not so sure. One unintended result of the crackdown on corporate fraud and investment banking malfeasance is the demise of research analysts covering new and small companies. Newly public companies, if not covered by the analysts employed by the investment bank which brought the company public, often have no research coverage at all, which in turn means institutional investors will probably not invest in these stocks.

But consider this: When Intel went public in 1970, it offered $8 million of stock and sported a market value of $53 million.

Today about 60 percent of the stocks trading on the Nasdaq stock exchange have one equity research analyst covering them, and 40 percent have none. Not surprisingly, the combination of the absolute abandonment of small- to mid-cap research and market-making by underwriting firms, and radically higher costs for small cap-issuing companies, has substantially raised the bar for the size of company that can go public on today’s Nasdaq.

As recently as 1996, the average deal size of a Nasdaq IPO was $34 million, and the average market capitalization was $133 million. Ten years later, the average IPO deal size was $113 million, and the average market cap was over $330 million—a size that only a much bigger company can sustain. Some of this is the inevitable byproduct of the spectacular crash of the late 1990s technology bubble, during which it was clear that some companies went public too early.

But consider this: When Intel went public in 1970, it offered $8 million of stock and sported a market value of $53 million. Cisco Systems Inc.’s IPO in 1990 raised only $50 million, at a price which yielded a post-deal market cap at IPO of $226 million. E*Trade Financial Corp.’s initial offering raised $59 million in 1996 at a market value of just $165 million. The point is that these companies created the majority of their value and the jobs that came with that value after they were public. Today, these three companies sport market caps of about $126 billion, $160 billion, and $9 billion, respectively, and employ among them hundreds of thousands of people.

Today, unfortunately, few if any of these deals would be doable. The offering and overall market value of companies akin to Intel, Cisco, and E*Trade would be too small for most underwriters. The more likely outcome is that the companies would be sold. In fact, again for the last six years running, 90 percent of all the exits from venture-backed companies have been through mergers-and-acquisitions transactions instead of through the IPO market, which accounted for well over half of the exits in the 1990s.

This is the real competitiveness issue. The evidence suggests that we are now killing our most promising companies, our future “national champions,” before their time. Does anyone seriously believe Cisco would have grown more if it had been acquired by Digital Equipment, or that Microsoft would have thrived inside IBM?

Most young tech companies that manage to go public today end up berthed in the so-called “orphanage” among other penny stock listings, with the stock price trailing off, and trading diminished to the “trading by appointment” level; this is particularly true if they go public through the back door—by virtue of a shell or so called SPAC reverse public offering. Penny stock listings are not just illiquid, meaning they lack enough trades to generate interest among general investors. They are also ripe for manipulation by stock speculators. Such a financial environment tilts strongly against the IPO as an exit mechanism for venture capitalists and their entrepreneurs.

Add in the geometric increase in litigation by the plaintiffs’ bar as stock prices spiral downward and you have a situation where an increasing number of issuers in the venture space will simply dump the IPO prospect and sell out at the first opportunity. This is bad news all around for the venture industry.

Pragmatic Policy Steps

But caution is, of course, the rule in this area when considering reforms. U.S. securities regulation has served this country, and the EVITA sector, well since 1933. So what to do? There are several steps to take.

We need to enact so-called “broker/dealer lite” regulation, which would qualify the hordes of unregistered “finders,” many quite legitimate, who currently operate as money finders in a legal “gray area.” The Securities and Exchange Commission has rightly concluded that private placements will be advantaged if companies willing to abide by a realistic rule are offered a relatively inexpensive and uncomplicated system—the “lite” in broker/dealer “lite”—for registering that recognizes their limited scope of operations. The regulation is on the launching pad—we need to launch.

We also need to clean out the 10,000 or so nominally public companies with no reason to remain public other than providing a feeding ground for penny stock fraud. The ability to take, at reasonable costs, companies in the so-called orphanage and make them private again, or to merge them, will clear the U.S. markets of confusion and clutter. We need a streamlined system for micro-caps to revert to private status fairly and cheaply.

We also need to re-open the IPO window for venture-backed companies with market caps between $200 million and $700 million by, among other things, developing new regulations and new incentives for equity research analysts to provide unbiased research coverage of these companies for institutional investors. The trick is to work out compensation regimes for coverage of mid-cap companies by talented people. The British know how to do it and we can take a page out of their book.

Finally, I believe we need to pull together the best minds to work out a new trading system that will enable qualified private issuers—emphasis on qualified—to file on their Web site, if they so elect, information which mimics the digital data rooms that VCs require in EVITA transactions—and not a 200-page prospectus designed to please an audience of bureaucrats—and permit limited trading among qualified—emphasis again on qualified—investors. These two steps would server as a warm up to a full dress, fully baked IPO if intermediate market performance warrants it.

What’s more, the clear need for young tech companies to be able to tap public equity capital markets earlier in their existence is critical to our nation’s long-term scientific and economic competitiveness.

Such systems are coming into vogue in the institutional debt market. I have long plumped for a similar facility, adapted to the EVITA economy with appropriate safeguards, such as admission to the exchange through a strengthened investor-identification system—the so-called NOMAD system—as employed by London’s Alternative Investment Market. The idea is to relax conditionally—as the SEC has promised—the so-called “general solicitation” disqualifier under Regulation D and free up sophisticated angel investors and their registered advisers to kick the tires of a number of promising companies, finding the ones which trigger interest.

Post investment, these qualified institutional investors would then have limited “liquidity opportunities”—a chance to sell their shares in these promising companies—so that conventional IPOs could go forward once the candidates have been able to navigate spring training. Such a system would allow those young companies that have achieved passing grades from the sophisticated investor community to qualify, based on the track record during spring training, for a public listing.

None of these steps are easy to take given the complexity of the issue and the various legislative and regulatory players involved in the reform process. But neither are these reforms beyond the capabilities of dedicated policymakers to craft. What’s more, the clear need for young tech companies to be able to tap public equity capital markets earlier in their existence is critical to our nation’s long-term scientific and economic competitiveness.

Science Progress is dedicated in part to exploring these and other issues related to the financing of science in this country. The purpose: to illustrate to science-and-technology academic researchers and entrepreneurs, venture capitalists, other financial investors, and state and federal policymakers that careful financial regulatory and tax reforms can ensure the U.S. economy continues to prosper due to the robust commercialization of innovation.

Joseph Bartlett, an advisory board member of Science Progress, serves as counsel at Fish and Richardson P.C.; Courtesy Professor, Johnson School of Business, Cornell University; and Founder and Chairman of VC Experts. Inc.

That said, monopolies never last forever. Our clear lead in what I call the EVITA economy—Entrepreneurial, Venture-backed, Information–dependent, Technology-flavored Activity—now faces rising competitive challenges from global competitors—a natural, inevitable, and, of course, healthy phenomenon. Indeed, the good news is that an innovation-led global economy is certain to prosper exponentially, in this country and globally, given the tsunami of explosive advances in science and technology the world is currently experiencing.

For three decades, venture capital-backed startup companies have been the job-creating engine of the U.S. economy.

Unfortunately, serious (and unhealthy) challenges to the bedrock of our nation’s entrepreneurial, innovation-led economy—start-up technology companies of all stripes—threaten to limit our economy’s ability to remain hyper-competitive across a range of existing and emerging high-technology industries and services. The reasons are manifold but largely stem from unintended consequences resulting from the insufficient allocation of financial and human capital and misguided policymaking. The following essay will first define our EVITA economy and then suggest a blueprint for future U.S. economic policy designed to grow innovative new tech companies intelligently and productively, yielding benefits that are socially positive, widely distributed, and fairly allocated.

The EVITA economy

The United States is unusual in that many of its strategically vital corporations are young and competitive, contributing enormously to our national prosperity. In 1990, Microsoft Corp., Dell Computer Co., and Cisco Systems Inc. had combined sales of $2 billion. By 2000, their combined sales hit $80 billion before leveling out at around $90 billion in this decade as they gained blue chip status. Such growth exemplifies why companies backed by venture capital generate twice the sales, pay three times the federal tax and invest far more heavily in research and development than their traditionally financed counterparts.^[1]

“Entrepreneurship is what enables American-style capitalism to be generative and self-renewing,” observes Carl Schramm, head of the primary U.S. research institute on venture capital, the Kauffman Foundation. Schramm, however, then adds a cautionary note: “The system that generates and supports entrepreneurship in the United States is surprisingly unappreciated.”^[2]

My take on the subject: Schramm is putting it mildly. For three decades, venture capital-backed startup companies have been the job-creating engine of the U.S. economy. According to a study by the consulting firm Global Insight released by the National Venture Capital Association recently, startups backed by venture capital since 1970 today employ 10 million Americans, and in 2005 generated sales of $2.1 trillion. These companies employ over 9 percent of the U.S. private-sector work force and account for an astounding 16.6 percent of GDP.

This is astounding when you consider that the $23 billion invested by venture capitalists in 2005 represented only 0.2 percent of GDP. Talk about a bang for your buck. These companies—from Apple Computer Co, Intel Corp., Cisco, Amgen Inc., FedEx Corp, and Google Inc. to the up-and-coming mobile technology and lifesaving drug and device companies of today—have generated far higher than average wage growth, have accounted for a significant and growing proportion of U.S. civilian research and development, and have spawned some of the most innovative products, services, and business models of our era.

But we ain’t seen nothing yet. Giant technological leaps are in their infancy. If all we do is develop biotechnology innovations currently under development, then an average (and active) life span of 100 years is a cinch. Fossil fuels will be, in fact, fossils. Management information systems will revolutionize health care as computer-driven artificial intelligence facilitates diagnoses. Across our economy, one “pipe” will carry interactive video, audio, and the Internet into every home. Global Positioning System-driven satellite systems will drive (literally) every terrestrial vehicle, air, and sea vessel. And this is only the low hanging fruit. According to world class physicist Freeman Dyson:

Two facts about the coming century are agreed on by almost everyone. Biology is now bigger than physics, as measured by the size of budgets, by the size of the workforce, or by the output of major discoveries; and biology is likely to remain the biggest part of science through the twenty-first century. Biology is also more important than physics, as measured by its economic consequences, by its ethical implications, or by its effects on human welfare.

These facts raise an interesting question. Will the domestication of high technology, which we have seen marching from triumph to triumph with the advent of personal computers and GPS receivers and digital cameras, soon be extended from physical technology to biotechnology? I believe that the answer to this question is yes. Here I am bold enough to make a definite prediction. I predict that the domestication of biotechnology will dominate our lives during the next fifty years at least as much as the domestication of computers has dominated our lives during the previous fifty years.

Yet serious impediments exist in our capital markets today which could well inhibit venture capital-backed startups from commercializing these existing and future technologies, among them:

• Too many notional “public” companies whose shares are too small to trade unless promoted by unscrupulous crooks
• Too few opportunities for young high-tech companies to go public through an initial public offering without sharing a stock market listing with these crooks
• Not enough equity-flavored compensation—options—for gifted managers^[3]
• Not enough sensible tax incentives^[4]

Enhancing the EVITA Economy

The first challenge, then, is for public policymakers to examine federal regulations so that our economic and financial policies foster entrepreneurialism, not only to preserve the EVITA economy in its present form—by attacking bureaucratic micromanagement that violates the primum non nocere (first do no harm) principle—but also to unshackle capital-raising opportunities for young tech startups so that they can grow exponentially by matching the growth in scientific and technological innovations which loom ahead of us and, in the process, spreading the benefits to all willing to put in the necessary elbow grease.

Policymaking opportunities to boost innovative companies would:

• Facilitate the flow of more private capital into early-stage startups so as to minimize a palpable financing gap between available capital and promising proposals.
• Reform the irrational blockage in the pipeline between university research labs and venture investors, an aberration which has minimized the ability of universities and medical schools to commercialize technology through spin outs in which the lab owns a meaningful equity interest.
• Enable investors below the level of multimillionaire angels to diversify a prudent portion of their investment portfolios into well managed venture funds through 401(k) and IRA pension plans by tweaking the Business Development Company amendments to the Investment Company Act.
• Open the venture financing doors to women VCs, tech entrepreneurs, and social entrepreneurs to diversify the range of ideas open to commercialization.
• Spread venture capital-driven entrepreneurialism beyond the East and West Coasts into communities across the United States by promoting regional innovation centers of excellence.
• Enhance small-capitalization stock exchanges in the United States, such as the NASDAQ Small Cap and NYSE Arca exchanges, so they rival London’s Alternative Investment Market.^[5]

Each of these policy-reform measures will require careful analysis before implementation. But none of them is difficult to envision as part of a concerted effort to create more venture capital-backed opportunities for entrepreneurs across the United States.

Science Progress is dedicated in part to exploring these and other issues related to the financing of science in this country. The purpose: to illustrate to science-and-technology academic researchers and entrepreneurs, venture capitalists and other financial investors, and state and federal policymakers that careful financial regulatory and tax reforms can ensure the U.S. economy continues to prosper due to the robust commercialization of innovation.

Joseph Bartlett, an advisory board member of Science Progress, serves as counsel at Fish and Richardson PC; Courtesy Professor, Johnson School of Business, Cornell University; and Founder and Chairman of VC Experts. Inc.

Notes

1) Companies backed by venture capital generate $643 in sales for every $1,000 in assets, compared with traditional companies, which have only $391 in sales. Venture-backed firms also spend considerably more m money on research and development costs: $44 per $1,000 in assets compared with $15 for others. In 2003, approximately 11 of every 100 working adults in the United States were engaged in entrepreneurial activity, either starting a business or playing a lead role in one less than three and a half years old. That rate is higher than any in Europe and roughly twice that of Germany or the United Kingdom.

2) Schramm, “Building Entrepreneurial Economies,” Foreign Affairs, Jul/Aug. 2004.

3) Bartlett & Lundberg, “New Executive Compensation Model,” available at http://www.fr.com/news/articledetail.cfm?articleid=723

4) As William Megginson observers concerning the influence of European governments on private equity:

European governments have long taken an activist approach to the promotion of VC investment. Unfortunately, both academic research and anecdotal evidence indicates that government efforts to promote a robust entrepreneurial sector would probably be better focused on eliminating regulatory roadblocks, lowering taxes, and providing a more favorable overall business climate than on attempting to directly identify and fund ‘sunrise’ industries. …

5) See www.vcexperts.com, Book 19, The Encyclopedia of Private Equity and Venture Capital, “New Trading Platforms: Alternative Investment Market (“AIM”); NYSE Arca; The Pink Sheets.”