Angels of Risk

Build a better mousetrap and the world will beat a path to your door--provided that adequate financing can be arranged to cover initial production and marketing expenses. As many an underfinanced entrepreneur has learned, the road to penury is paved with good inventions. Now there is an invention designed especially to provide backing for fledgling tycoons: the venture capital industry. After a decade or so of ups and downs, it is emerging as one of the most important sources of funds for new businesses.

Some 600 firms with total assets of about $3 billion are devoted solely to raising and dispensing venture capital. Their number is down somewhat from the boom years of the mid-1960s, but up substantially from the recent recession. Venture capitalists now provide as much as $700 million a year in financing for new or expanding businesses.

The only requisites for joining the ranks of venture capitalists are a large pool of money and a penchant for gambling. The industry is an amorphous collection of risk takers: wealthy families (including the Rockefellers and Whitneys), large corporations (Emerson Electric, Dow Chemical, Exxon), groups of private investors and the 320 Small Business Investment Corporations. S.B.I.C.s, which will dispense a total of $100 million in new financing this year, are groups of private investors who supplement their own capital by issuing Government-guaranteed debentures. This week the Small Business Administration, which regulates S.B.I.C.s and sells their securities, will open bids for $39 million worth of S.B.I.C. debentures, the largest offering ever.

Iffy. Banks and the stock market are still common sources of cash for expanding businesses. But a bank loan burdens an already cash-short entrepreneur with interest payments, and new issues of stock in small, young companies are not as easy to sell as they were in the 1960s. Venture capitalists fill the gap by buying an ownership stake in struggling companies. They will back just about any kind of business that shows a potential for making profits; Narragansett Capital Corp. of Providence, R.I., is now bankrolling ventures in cable television, soft-drink bottling and women's overcoats, while Cumberland Associates of Manhattan is investing in real estate and ice cream-making firms. In return for his money, the venture capitalist gets a piece of what he hopes will become the next Xerox or IBM.

Some investments approach that ideal. Allstate Insurance Co.'s private placement division maintained a growth rate of 40% a year during most of the 1960s by making prescient purchases in such companies as Memorex, Teledyne and Control Data. Chicago Financier E.F. ("Ned") Heizer has put his Heizer Corp. into a 32% ownership of Amdahl Corp., a computer maker that has booked $30 million of orders in its first year of production. The biggest hit of all was made by former Harvard Business School Professor Georges F. Doriot, who launched American Research and Development Corp. in 1946 as the nation's first publicly held venture capital firm and put $70,000 into the then tiny Digital Equipment Corp. Today that stake is worth $350 million.

For every big winner, though, there is a big loser--and a dozen iffy investments. Narragansett Capital, the nation's largest publicly owned S.B.I.C., has lost $1,081,000 bankrolling Sam Snead All American Golf, Inc. "A venture capitalist looks for a return of ten times his original investment," says Harlan Anderson, head of Anderson Investment Co. in New Canaan, Conn., "but you're lucky if you get that kind of return in one case out of ten, so it evens out." And some venture capitalists go bust along with the businesses they buy into; 400-odd S.B.I.C.s have perished since 1964.

In an effort to avoid such disasters, venture capitalists do some furious winnowing to keep potential losers out of their portfolios. Business Development Services Inc., a subsidiary of General Electric, has put money into only 16 of the 2,000 firms that have sought its help in the past four years. The most generous venture capitalists aid no more than one of every 30 applicants--and he had better come armed not just with a good idea but a prototype of his product and a detailed survey of the potential market. Even the entrepreneur who passes that test can find that his financial angel is also a dictator who may not let the founder keep a majority of his own company. Says Paul Bancroft III, vice president of the steel-rich Phipps family's Bessemer Securities Corp.: "I do not want the president to have control. If his management is not going to make it, you have to be prepared to remove him."

Apart from the eternal problem of making what by their very nature are high-risk investments, venture capitalists face some other dangers. Rising interest rates are beginning to hurt those who supplement their own capital by borrowing money. Support is growing in Congress for proposals that would curtail the present liberal tax treatment for capital gains--now one of the prime incentives for wealthy investors to form venture capital groups. But as long as cash-strapped entrepreneurs dream of building giant companies, and wealthy investors savor the excitement of backing new ideas, the venture capital industry will be around.

This file is automatically generated by a robot program, so reader's discretion is required.