Overshooting and Undershooting: Scale Venture Partners’ Kate Mitchell and Rory O’Driscoll on the VC Pendulum Swing

Part of the point of opening Xconomy San Francisco last month was to put our ear to the ground in the world capital of venture investing. Toward that end, I sat down earlier this week with Kate Mitchell and Rory O’Driscoll. They’re both general partners at Scale Venture Partners, a Foster City, CA-based firm that focuses on helping startups through the middle stage of their growth—after they’ve proved that there are at least a few customers for their products, but before they’ve shown that there are lots of them.

That’s an unusual and tricky place for a venture firm to dwell, and it means that Scale’s team is heavy on partners with operating experience, especially in sales, marketing, and business development. In fact, Mitchell herself co-founded the firm in 1996 after working at Bank of America, where she had guided the development of the bank’s first Internet offerings. (Scale was known as BA Venture Partners through 2006, reflecting Bank of America’s majority ownership in its early funds. The bank has been a minority partner in Scale’s last two funds, a $400 million fund launched in 2007 and a $255 million fund launched this year.) O’Driscoll, meanwhile, has a background in manufacturing and has been a venture investor for nearly two decades, working with mobile, Internet, and enterprise software companies from Omniture to Box.net.

Lately, Mitchell has had a second job as well: chairing the National Venture Capital Association, the main trade association representing the venture industry in Washington, D.C. In that role, she’ll face many of the same challenges as her predecessor, Polaris Venture Partners’ general partner Terry McGuire. It’s her responsibility now to promote legislative changes such as immigration reform that the association sees as key to boosting innovation and entrepreneurship, while at the same time working to prevent changes that she says could make venture investing a less attractive career path, such as proposals to raise taxes on carried interest.

She’ll also have to help the industry through what’s likely to be a rough patch in the next two or three years, as limited partners react to the subpar investment returns of the past decade by pulling money out of this risky asset class. It’s a shakeout that Mitchell describes as necessary and healthy, but it’s one that will likely be painful for venture firms and entrepreneurs outside the Silicon Valley and Boston corridors, where the venture ecosystem is bigger and more likely to be able to weather the shakeout.

We had a wide-ranging conversation that focused first on the overarching trends and policy issues affecting the venture industry, and then on the way Scale picks its investments and works with the companies in its portfolio. I’ve divided my writeup of the conversation in the same way. In Part 1, published here, Mitchell and O’Driscoll tackle my questions about the health of the venture industry. In Part 2, coming next week, the conversation will focus on the unique challenges facing companies in the middle stages of their growth, and how Scale helps them scale up (hence its name).

Xconomy: Let me ask you to put your NVCA hat on first and talk about the big picture for the venture industry. How would you describe it right now?

Kate MitchellKate Mitchell: This is one of the greatest times, but it’s also one of the worst times. It’s a bit of both. It’s a record low time for money coming into the industry, but it’s probably the best time to invest.

Our thesis is that we are finally getting the excess capital out of the industry. We created too many competitors, too many entrepreneurs chasing the same opportunity, so they had to compete on price. We need to trim the tree or go on a diet, whichever metaphor you like. You never want to be the limb that gets pruned or the pound that gets lost, but we all know we’ll be healthier at the end of the process.

The only negative right now is that in many regions, venture fundraising has become much more of a challenge. In any place except Boston and Silicon Valley, it’s harder. I was in Michigan recently. I met with the Michigan Venture Capital Association, and they are worried. The average VC fund size in Michigan is $39 million, and they are worried about raising their next funds. So that’s one of the negatives of this part of the cycle, that the opportunities have receded somewhat to Silicon Valley and Boston.

X: Isn’t it inevitable that as the number of LPs investing in venture as an asset class shrinks, there will be a flight to quality?

Rory O'DriscollRory O’Driscoll: I dislike the term “flight to quality.” It’s more that there is a flight to the sure thing, and that is more likely to be an established firm. If Silicon Valley has 200 firms and it goes to 150, you barely notice. But if someplace has five firms and it goes to one, you really notice. It’s just more obvious in the regions, where a small absolute number of funds closing down really makes a lot of difference.

Stepping back, the industry massively overshot the amount of capital it could effectively use in 1999-2001, and it was above what the long-term number should be right up to and through 2009. We now think it has broken to the downside. Markets that overshoot by 10x are perfectly capable of undershooting by 2x. So it wouldn’t surprise us if there was an undershooting for the next two to three years—in other words, people putting less money into the business than the business warrants. You’ll see that in the fundraising figures initially, and then in the fundings. Money will be harder to raise for venture firms, and then harder to raise for startups.

KM: As a balancing trend, excluding cleantech and healthcare, entrepreneurs are a lot more efficient. Even for Facebook, initially building the company was very capital-efficient. More gets used in the later stages of actually scaling the business. There, companies can attract broader capital, from the likes of Microsoft or Google. So I don’t think the big successes will be starved for capital.

X: But is there anything that can be done to soften this “undershooting” when it comes to the regional venture capital picture? In places that Xconomy covers, like San Diego and Detroit, I think there would be a lot of concern that if the local venture funds go away, the local startups won’t getting the support they need.

KM: There may be more venture funds that are funded in Boston and Silicon Valley as a percentage, for a period of time. But I don’t know that that translates one-to-one to where the startups are. We have great company in our portfolio in Indianapolis, Exact Target, that just acquired a San Francisco company called CoTweet. It’s a big, $100 million company.

RO: You can definitely build successful companies in these places, and they will get a lot of money. For Exact Target, two of the board members fly in from California. One flies from Boston, and we’re happy to do it.

KM: But it is hard in places like Michigan. We are going to have the problem of undershooting, and there is no easy answer, because it’s the natural pendulum swing.

Seed investors and “super-angels” have been willing to come in, in certain areas. There is a group of next-generation, smaller funds operating in New Mexico, Colorado, Idaho, many of whom are really super-angels, who are looking for deals regionally. They are great people for us to pair with. We did work with the Angel Capital Association, from a policy standpoint, on making sure that some far-ranging potential changes that would have made it more difficult for these angels to invest did not go through.

X: You’re talking about the SEC registration issue.

KM: It was accreditation. The SEC was threatening to raise the level of a “qualified investor” and what kinds of assets it took so high that it would have aced out a lot of angels. We helped them come back down. The ACA was very happy with the result of that.

X: Speaking of legislation, the NVCA was also working this year to head off changes in the way venture partners are taxed on their income from carried interest, the money they make on venture exits when portfolio accompanies get acquired or go public. The question was how much of carried interest income should be taxed as regular income, and how much under the lower capital-gains rate. Where does that issue stand now—is it off the table?

KM: What happened was that the changes got lumped into the R&D tax credit extender bill, then into a bill for unemployment insurance. The question was how do you pay for the goodies, and we became associated with that—“we” meaning, broadly defined, the private equity industry, including partnership taxes for hedge funds, real estate firms, private equity firms, and then the little teeny-tiny venture capital industry. The tax extender bill failed for other political reasons, and unemployment insurance sailed through this week on its own.

Does the tax extender get reinvigorated before the election, or in a lame-duck session after the election? That’s tough to know at this stage. It’s not a zero likelihood. We have delayed it, but we haven’t solved it by any stretch of the imagination. We had worked out a compromise under which [carried interest] would be treated as some blend of ordinary income and capital gains for investments held over 5 years. Will the compromise hold if it does come up again, when more goodies need to be paid for? We’ve kicked the can down the road, on the one hand. On the other hand, a lot of entrepreneurs and VCs and ultimately professors—including Phil Sharp at MIT—signed a letter to President Obama saying “Who do you think is going to help take things out of my lab at MIT if it’s not the VCs?”

X: Can you explain why venture partners shouldn’t be asked to pay somewhat higher taxes on their windfalls from venture exits? I also wonder how this issue affects innovation more generally. I would think that the way limited partners are taxed would be much more significant for the venture industry and its customers, in the end, than the way general partners are taxed.

KM: The NVCA was founded 40 years ago around legislative changes to get capital-gains treatment for profits from long-term investing. So that is a structure that has existed for a long time. I think there is ultimately an issue of how you are going to incent people. If you get taxed on ordinary income for a deal that takes two or three years, and you get taxed in the same way on a deal that takes 10 years, are you going to want to do the 10-year deal? There would be no incentive to 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.

Wade Roush is a freelance science and technology journalist and the producer and host of the podcast Soonish. Follow @soonishpodcast

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