take long-term risk. You would also end up with a skew where there would be more reliance on management fees, which would create a lack of alignment with LPs.
There was just a Deloitte study that measured global sentiment about venture capital. External to the U.S., there is a lot more enthusiasm about venture capital. In the U.S., the response was very much tainted by a lack of certainty around regulations, and that is affecting our whole industry.
X: So, in the big picture, both of you are saying that the venture industry is prone to these wild but apparently inevitable pendulum swings in terms of capitalization, and that it’s also vulnerable to uncertainty around regulation. Does that mean “venture is broken,” as so many have been saying?
RO: It’s not broken. I don’t think that survives detailed analysis. It’s possible that something that has worked for 30 or 40 years and has generated 20 percent of our gross domestic product has changed, but I’m not prepared to assume that. There is no evidence that any other form of capital allocation works. Europe has a highly state-directed venture capital system, and entrepreneurship in Europe is an extremely tough row to hoe.
KM: The way we look at it is, venture is unique in its ability to take losses, within a management structure that can’t be duplicated by individuals, with expertise that can’t be replicated by government, with investors and individuals who are accustomed to taking a certain amount of losses. The proof is in the pudding, and in the fact that everybody else is imitating our system. China has already lowered its capital gains tax rate to 10 percent and is talking about lowering it to zero. These people are literally copying our model.
X: But let me ask my question again. You pointed out that a huge percentage of our GDP is generated by venture-backed companies. But you also acknowledged that the venture business is prone to these cycles of overshooting and undershooting—which means that many silly ideas get funded during the boom times and many worthy innovations don’t get funded in the bad times. Just to play devil’s advocate—is this really any way to run an economy?
RO: It’s hard to come up with a better system. I think not making it worse would be a good start. Consistency in government policy would be the most useful thing to dampen out the cycles, because the more predictable, the less likely you are to accentuate the fluctuations. But the reality is that the innovation process is bursty. You have these bursts of innovation, and everyone piles on, and then there is a culling, and then it happens again. There is no other way than to tolerate the breakage. There is no way to “rationally” allocate capital, because if I knew in advance which deals were going to work, I’d only do those deals. There is no other way of doing it, other than living with a certain amount of chaos. When you see the kinds of returns that some of the good deals are bringing, there is going to be overcrowding, and some are going to die.
KM: Making venture investing less attractive just at the time when the system is overcorrecting seems like the wrong thing to do. There should be an incentive for long-term investing, just like there is an incentive for charitable contributions. One of my tenets is that you see venture investing go up and down, up and down, but innovation has been a constant. The model of supporting innovation isn’t broken. When we bring legislators to Silicon Valley and they see the enthusiasm and the jobs being created, they say “Wow.”
Coming next week in Part 2: How Scale Venture Partners invests.
