Venture capital firms: Specializing in investments

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  • Journal of Strategic Change, Vol. I , 297-313 (1992)

    W. Keith Schilit University of South Florida College of Business Administration, Tampa, Florida, USA

    Introduction

    More and more, we have evolved into a niche economy. This has been characterized by emerging growth companies carving out small, specialized niches, and then filling them better than anyme else can. Informa- tion America (Atlanta, GA), for example, provides on-line public record information and services to lawyers. Similarly, Roadshow Services (San Francisco, CA) provides trucks and drivers for performers and Backroads Bicycle Touring (Berkeley, CA) markets van- supported bicycle tours. Each of these companies was founded less than 10 years ago and is now a multi-million dollar business.

    The diversity of these niche oriented businesses is startling. Among the most recent Inc. 500 listing of fast growth private companies, in addition to the three companies just mentioned which have grown by at least eight-fold over the last 5 years, you would have other comparably successful companies in such specialized areas as archery equipment, handcrafted embroidery, Australian wines, parent education videos and model racing cars.

    Therefore, just like the trend towards specialization among entrepreneurial companies, it should not be surprising that

    Venture capital firms: specializing in investments

    his article discusses current T trends in the venture capital industry, particularly the increasing trend to wards specialization.

    I t should not be surprising that there has been a dramatic

    trend towards specialization among venture capital firms

    there has been a dramatic trend towards Specialization among venture capital firms. This has been one of the most significant recent developments in the venture capital industry. It has also been a very positive development for the industry and for entrepreneurs in that it has prompted venture capitalists to develop greater expertise in companies in a given industry, stage of development, etc.

    The purpose of this article is to examine the emerging trend towards specialization that has developed in the venture capital industry.

    A niche economy results in specialization among venture capitalists

    Certainly there are several venture capital firms that tend to diversify their investments. For example, US Venture Partners, a $0.25

  • 298 W. K. Schilit

    billion, Menlo Park, CA, based venture capital firm, has attempted to maintain a balanced portfolio of early and late stage investments, throughout the country, in such diverse areas as technology, specialty retailing and consumer products. Consequently, they have invested in such companies as: Applied Biosystems Inc., a manufacturer of analytical instruments for genetic engineering, research (which went public in 1983); Sun Micro- systems, a manufacturer of computer work- stations (which went public in 19816); Home Club, a chain of warehouse style home improvement retail stores (which was acquired by Zayre Corp. in 1986); Ross Stores, an off-price apparel retailer (which went public in 1985); and Avia Group International, a manufacturer of athletic footware and clothing (which was acquired by its rival, Reebok International, in 1987).

    However, we have begun to witness a different type of investment pattern among many venture capital firms. For example, MedVenture, a San Francisco based venture capital firm, limits its investments to the life sciences, i.e. biotechnology, health services, medical instrumentation, etc. Similarly, Julian Cole & Stein, of Los Angeles, generally invests in high-tech manufacturing companies on the West Coast, as evidenced by their recent investments in LascerCom, a manufacturer of detectors and transceivers, and Advanced Power Technology Inc., a manufacturer of MOS transistors.

    As noted by David Brophy, Professor of Finance at the University of Michigan:

    Theres an evolution going om in the structuring of the industry . . . The old model, in which the venture capitalist was a generalist, confident that he could deal with any type of venture, is no longer possible. Because of the intense competi- tion for money and deals, were seeing much more targeting of specific areas of technology and growth.

    See Lee Kravitz (1989, What venture capitalists want. In Ventures Guide to Internation(a1 Venture Capital. New York: Simon & Schuster, p. 14.

    Liberal exception policy

    Even with specialization, many venture capitalists will deviate from their preferences. Some venture capitalists refer to this as their liberal exception policy. For example, Brentwood Associates, a specialist in funding high-tech ventures, invested in Midway Airlines a few years ago. Why? Because, above all, the characteristics of the people involved in the venture are more important than the industry in which they operate.

    Even with specialization, many venture capitalists will deviate from their

    preferences

    There is a misconception that early stage high-tech companies in high-tech regions are the sole recipients of venture capital. As we will soon see, however, with increasing specialization there has been a shift in venture capital commitments that has resulted in considerable funding to low-tech industries in low-tech regions at late stages of develop- ment.

    Specialization by region

    In general, venture capital firms are located in regions in which entrepreneurial activity is greatest. Specifically, the three leading states for Inc. 500 fast growth private companies in this country have been California, New York, and Massachusetts; not surprisingly, these three states have the largest number of venture capital firms.

    In general, venture capital firms are located in

    regions in which entrepreneurial activity

    is greatest

    Journal of Strategic Change, October 1992

  • Venture capital firms 299

    Venture capital firms, especially those in California, often concentrate their invest- ments in their own region. For example, there are dozens of West Coast based venture capital firms-such as Julian Cole & Stein (Los Angeles, CA), MedVenture (San Francisco, CA), Menlo Ventures (Menlo Park, CA), etc. -which invest in ventures primarily in California. Similarly, Boston is well endowed with venture capital firms which invest primarily in Boston and the surrounding area.

    What about the other 90% of the land mass in the United States? Who invests in entrepreneurial companies in those areas, especially those in traditionally low-tech, low growth regions?

    Investing in companies in low tech, low growth regions

    With less than 10% of all venture dollars raised going to businesses based in the mid- west, some venture capital companies have begun to concentrate on this particular market niche, thereby specializing by region, rather than by industry. One such venture capital firm is Massey Burch, of Nashville, TN, one of the oldest and largest venture capital firms in the country. Massey Burch has invested a sizeable portion of its more than $100 million in paid-in capital to growth companies in the south-east. They have invested strongly-and wisely-in several companies in their own home town of Nashville, some of which have gone public, such as: Automotive Franchise Corp., which is involved in automotive service centres; Corrections Corp. of America, a private prison management company; Surgical Care Affiliates, which operates ambulatory surgical centres; and Southlife Holding Co., a life insurance holding company.

    Specialization by industry

    A second trend in specialization has been by industry, in either high- or low-tech products. For example, Plant Resources

    Venture Fund, a Cambridge, MA based venture capital firm, limits its investments to bioscience companies involved in agriculture, food, waste treatment and health care. As such, they have recently invested in such companies as: The Aqua Group (Tampa, FL), which sells and distributes aquaculture based seafood; AgriTech Systems Inc. (Portland, ME), a leading supplier of diagnostic kits for detection of disease in poultry, swine, cattle and horses; and Sunseeds Genetics, Inc. (Hollister, CA), a developer of improved vegetable seeds.

    Computers and office automation

    In recent years, approximately 30-40% of the Inc. 100 companies (i.e. the fastest growing small public companies in this country) have been in computers and related industries. More impressive than that is that over a dozen start-up companies in the computer industry have attained Fortune 500 status over the past 20 years. Such success stories, which include Intel, Apple, Tandem, Compaq and Sun Microsystems have been more than companies; they have been the emergence of industries. This has en- hanced the impact that the computer industry has had on the venture capital industry.

    The decline of investments in computer hardware

    Of course, the statistics just cited deal generally with ventures which were originally funded more than 5 years ago, and have since gone public. More recently, the situation has changed dramatically. This will become evident in the Inc. 100 list for 1993 and beyond, since there is a lag of 5 years

    There is a lag of 5 years or so between the time that a company raises

    venture capital and the time it goes public

    Journal of Strategic Change, October 1992

  • 300 W. K. Schilit

    or so between the time that a company raises venture capital and the time it goes public. According to a recent Venture Economics report, there has been a steady decline in venture capital investments in the computer hardware industry-from 33% of the total capital invested in 1983 to 13% in 1988. This decline has continued in recent years. According to a recent Technologic Computer Letter, a newsletter of the computer and electronic equipment industry, venture capital investments in this industry de- clined by more than 10% from 1988 to 1989.

    Why has that occurred? Consider Stardent Inc., a manufacturer of graphics workstations for scientists and engineers. Stardent is the result of the merger of two of the best financed, yet most disappointing, computer start-ups in history--Ardent Computer Corp. which, thanks in part to the backing of Kubota Ltd. (Japan), raised $108 million, and its former rivail, Stellar computer Inc., which raised $60 million. A public offering for Stardent is still far away.

    There are several reasons for the declining level of investments in computer hardware. One of the problems in the computer hardware industry is that most of tlhe niches are already filled; moreover, those niches that remain will probably not offer the explosive growth opportunities of such one- time early stage niche players as Apple, Microsoft or Compaq. In addition, the lifespan of products has shortened dramatic- ally. Consequently, computer companies are replacing product lines every 1-2 years, rather than every 4-5 years as ithey had previously done.

    Perhaps the biggest concern among venture capitalists is the risk/return balance of such investments. As was seen with Ardent Computer and with Stellar Computer, the start-up capital could be enormous -. $20- 100 million or more. Once that has been invested, it is not even certain there will be a product; even if the company develops a prolduct, the market can be uncertain and the competition can be fierce.

    Whats NeXT?

    One of the biggest question marks in the computer industry is Steve Jobs latest venture, NeXT Inc. The company is well capitalized. Early stage investment came from Jobs ($7 million), from Stanford University ($658,000), and from H. Ross Perot ($20 million). More recently, Canon Inc. invested $100 million for 16% of the company (thus giving NeXT a valuation of $625 million before it sold its first unit). Yet at a meeting of a Technologic Partners Conference in 1988, a majority of the high- tech entrepreneurs and investors who were polled predicted that the company would not reach the $0.5 billion mark in sales. It may be difficult to dispute the logic of their forecast; however, I certainly would not want to bet against the intellect, the vision and the motivation of Jobs.

    Health care and biotechnology

    The health care and biotechnology areas have recently become prominent growth industries, as evidenced by the fact that 15-20% of the Inc. 100 companies have been in these areas over the last few years.

    Health care

    Recently, we have witnessed the tremendous growth of such health care procedures as electronic shock wave lithotripsy (ESWL- for breaking up kidney stones), magnetic resonance imaging (MRI), cardiac catheteriza- tion, coronary arteriography, etc. Con- sequently, several venture capital firms have been eager to invest in companies in such sectors of the health care industry as outpatient clinics, health maintenance, medical diagnostics, etc. This has been prompted by the successes of several companies in the health care field which have recently gone public.

    Home health care

    One notable area of growth in health care and delivery has been in home health care,

    Journal of Strategic Change, October 1992

  • Venture capital firms 301

    Home health care . . . has doubled in size over the last 5 years a n d . . . is expected

    to double again over the next 5 years

    which has doubled in size over the last 5 years and, according to Frost and Sullivan, is expected to double again over the next 5 years. Home respiratory care is currently a $ Yi billion industry that should soon generate a billion dollars per year. The same growth rate is expected for diagnostic cardiac units (which is now a $100 million business), intravenous infusion systems (currently $30 million) and breathing monitors (currently $20 million).

    In the last few years, a number of small public companies in the health care field, which were founded in the early 1980s and are now generating more than $20 million in revenues, typify the companies in which venture capitalists have made early stage investments. They include: New England Critical Care Inc. (Marborough, MA), which is involved in home health care; Healthcare Compare Corp. (Downers Grove, IL), a medical care cost management company; H.M.S.S. (Houston, TX), a home intravenous treatment company; Redicare (Newport Beach, CA), an operator of outpatient medical centres; and HealthSouth Rehabili- tation (Birmingham, AL), a company that develops and operates rehabilitation centres which has grown at a compounded annual rate of over 100% from 1985 to 1989.

    Of course, not all ventures have achieved their expected level of success. An example is Diasonics, a medical imaging company that manufactures nuclear magnetic resonance (NMR) machines, which was launched with the assistance of F. Eberstadt & Co., Hambrecht & Quist, and L. F. Rothschild Unterberg and Towbin. These venture capital firms paid approximately $ 1 per share for

    800,000 shares of the company. The company went public in 1983 for $22 a share, raising over $100 million in the process. Within a few years, however, Diasonics ran into t...