House Ready to Steamroll Venture Capital Bill

It’s baaack! Rep. Sam Graves, R-Mo., introduced a bill this week in Congress that would make significant changes to two of the government’s most successful small business programs: the Small Business Innovation Research (SBIR) program and the Small Business Technology Transfer (STTR) program.

The most controversial provision would re-open these key government conduits of small business research grants to more venture capital firms. The Small Business Administration (SBA), which oversees the program, limited venture capital firm participation in 2003 because of its interpretation of what constitutes a "small business."

The turf war has been underway ever since. But this time around, the venture capital industry’s chances of winning are greater than ever. In fact, it’s almost a lock. It’s not so much that the arguments have changed, or the playing field. But, as a result of the November elections, the key players have. Now, venture capital interests clearly have the upper hand. 

This bill has long been a top priority for the powerful National Venture Capital Association (NVCA) and the equally influential Biotechnology Industry Organization (BIO). The bill failed in previous sessions because small business groups and principally the Bush administration SBA opposed the VC provision.

Although Graves has sponsored the bill, House Small Business Committee Chairman Nydia M. Velazquez, D-N.Y., is once again quarterbacking the measure. She steamrolled it through her chamber last year -- it passed the House virtually without debate in a week -- and she is well on her way to doing it again.

The committee held a hearing on the bill last week (June 4); has scheduled a mark-up this week and will likely send it to the House floor in the next week or so. Once again, the hearing was only open to the venture capital community. Small business groups have tried to testify in the past, but have always been excluded. That alone sends up a red flag.

In any event, the Senate has been the major hurdle. The bill has died there repeatedly, largely because Sen. John Kerry, D-Mass., who chaired the Senate small business committee, was wary of the VC provision. But Kerry has moved on. The committee is now chaired by Sen. Mary Landrieu, D-La., and she’s co-sponsoring the Senate version of the measure with the committee’s ranking member Olympia J. Snowe, R-Maine.

Another key obstacle, SBA Administrator Steven Preston, who strongly opposed the change, left with the Bush administration. His job has gone to Obama appointee Karen Mills, who is a former venture capitalist and has strong ties to the industry.

Finally there is the president. Obama sees himself as the technology and innovation president and is enamored with the venture capital industry. He’s apparently bought into high-minded arguments about the role venture capital plays in the development of new technologies and products.

And those arguments are true, to an extent. Google, Genentech, Intel, Cisco, Starbucks, Microsoft, and FedEx are all venture capital success stories. But what this debate is really about are profits and return on investment.

These days, the venture capital industry is having a rough time. In fact, a growing chorus within the industry is questioning whether the current investment model is obsolete, or even broken.

Over the last 10 years -- the typical life of a venture fund -- venture investments returned 17.3 percent, compared with 2.1 percent for the Nasdaq and 1.4 percent for the S.&P. 500, according to The New York Times. But the industry is no longer generating the heady returns of its boom years in the 1990s, when firms raked in up to 3 percent in fees and as much as 25 percent of the profits when companies went public. 

In the last five years, the return has fallen by half, to 8.6 percent, although still outperforming the Nasdaq’s 3.1 percent gain and the S&P 500’s 3.2 percent gain. Last year, however, the industry lost money. 

Venture investments returned minus 1.6 percent in the year ended Sept. 30, according to data cited by The New York Times from the NVCA and Thomson Reuters. The returns represented a 6.9 percentage-point drop from the one-year period that ended June 30, 2008, and a 28.2 percentage-point drop from the one-year period that ended Sept. 30, 2007, according to Thomson Reuters’ U.S. Private Equity Performance Index.

It’s not for lack of capital. The venture capital industry has been awash in money. In fact, insiders say too much money has been chasing too few deals, artificially inflating the valuations of companies and cutting returns. In addition, the industry feasted off the development of the telecommunications industry. But that sector is now mature, and no other similar easy bets have emerged.
 
In other words, it’s getting harder for the industry to match its go-go years. As a result, big investors are pulling out, the number of venture capital firms is dwindling, and the industry is going through what The Wall Street Journal calls a brutal shakeout.

One way to juice returns -- and save the model -- would be to shift the burden of high-risk, early stage investments to the government programs, and target venture investments for late-stage companies where the chances of success are far greater and the risks are far lower.

Indeed, Jack Biddle, a founding partner at Novak Biddle Venture Partners, who testified on behalf of the NVCA, acknowledged as much. "It is for these new projects that these businesses would apply for an SBIR grant, as we venture capitalists cannot and will not fund early stage research."

The SBIR and STTR programs are ready pots of money. They direct more than $2 billion in federal research and development funding annually to small-tech firms across the nation, according to Snowe. I reported on the success of the program in one of my columns last month. You can check it out here.

The real problem is that the VC provision represents a zero-sum game. In other words, grants that go to firms now prohibited under SBA guidelines won’t be available to truly small, independent firms that now qualify. For every winner, there will be a loser.

In fact, some question whether the industry was all that beneficial even during its heady days. In a controversial report, the Kauffman Foundation asserted that venture capital is not as essential to high-tech and life-science industry growth as is widely believed. Between 1997 and 2007, for example, only 16 percent of the Inc. 500 list of fastest growing companies had received venture backing.

Of course, the venture capital industry heatedly disputes that view.

The final element weighing in the bill’s favor is the sorry state of the economy. Proponents have dressed up the bill as a job creator. Maybe so -- for the flagging venture capital industry.

But if Congress is serious about creating jobs it will leave the SBIR and STTR programs alone. Instead, the real debate should be about whether the venture capital industry’s 20th century business model is capable of meeting the president’s 21st century goals for innovation and technological development.