News

Federal government’s boost in VC funding comes under heavy criticism

At a time when most Silicon Valley venture
capitalists are pulling back, fearful that there’s
too much money chasing too few ideas, an
unexpected player has pumped in even more
money: Uncle Sam.

By Matt Marshall
Mercury News

The federal Small Business Administration is
channeling money to some small venture firms,
helping them inject $1.5 billion into California
start-ups in 2001. That’s up from $1.4 billion in
2000, and three times the level in 1998.

An Uncle Sam venture bubble? That’s right, say some steamed private VCs. They complain that Uncle Sam’s
weight is crowding out VCs who raised all their money by themselves. “They’re pouring gasoline on the
fire,” said Ted Dintersmith, a venture capitalist at Charles River Ventures. “No one is benefiting from the
capital excess. It hurts entrepreneurs, it hurts venture firms, and it is hurting limited partners.”

(Limited partners give money to VCs to invest in start-ups, hoping to garner a return when they run
profitable.)

“The Feds are totally out of sync with what is going on,” said Wade Woodson, a venture partner with Sigma
Partners in Menlo Park. “This is scary; the Feds are pumping money in when other people are giving it
back.”

Figures for 2002 aren’t available yet, but SBA administrators say the program is “counter-cyclical” and so
likely won’t show a significant decline. If so, the SBA-generated money could make up 12.5 percent of the
total invested in the valley.

The SBA program for VCs employs 93 people. It takes out a government loan and channels the money to
VCs who qualify — now about 66 funds in California. The SBA gives them up to $2 of funding for every dollar
they raise on their own. The VCs pay back the SBA loan over time plus a small percentage in profit.

There used to be a solid argument for the SBA. Back in the 1950s, it helped create the VC industry. Its
money later helped VCs spawn companies such as Apple Computer and Intel. “We feel pretty strongly that
we got this industry going,” said Mike Stamler, an SBA spokesman.

The rationale for the SBA’s matching program is that its VCs invest smaller amounts into start-ups and give
more hands-on attention, filling a space neglected by other VCs. But in a downturn, when all VCs are moving
to smaller investments and rolling up their sleeves, that argument fades, as even Stamler acknowledges.

Taxpayers aren’t losing any money — at least yet. There’s more of a problem for investors. The Internet
hype drew so much money from VCs that there’s not enough returns to go around. Start-ups are
cannibalizing each other and VCs are losing their shirts: Right now, VCs are investing about $22 billion
annually, and only getting $5 billion in return, Dintersmith calculates.

“With well-intentioned, but brain-dead programs like the SBA’s, you’re adding to the problem,” he says.

Brian Grossi is a venture capitalist at AVI Capital in Los Altos, which is SBA-backed. He argues that the
SBA-backed VCs may offer entrepreneurs more favorable terms, and so create healthy competition. But
that competition was part of what created the Internet bubble: VCs competed with other VCs to bid up the
paper value of companies, to the point where they were vastly overvalued.

The SBA money also might distort the consolidation going on in the VC industry, helping SBA-based venture
firms at the expense of their rivals.

Indeed, several Bay Area SBA-backed VCs have been scrambling to boost the amount of money they raise
from the SBA by acquiring smaller VC firms. Last week, Cupertino’s Novus Ventures gobbled up $11 million
in funds raised by Sausalito’s Artemis Ventures. That helps Novus leverage $22 million from the SBA and
gives it more staying power. Los Altos’ Aspen Ventures recently did the same with Saratoga’s Redleaf Group.
And Menlo Park’s Rocket Ventures is on the prowl for a similar acquisition.

Dintersmith and Woodson both say the government hasn’t been very good at figuring out who knows how to
invest money and who doesn’t.

“The SBA program has been drawn on by less experienced, less proven, less capable investing firms,”
says Dintersmith. Adds Woodson: “Money is given to investors that generally do not have the track record
to be able to raise money from conventional backers.”

Partners at Aspen, Novus and Rocket respond that their partners have a good track record, and their
portfolio companies have taken minimal or even no write-downs through the downturn. Let’s hope so. If they
don’t pay back their government loans, we taxpayers could take a bath.

http://www.siliconvalley.com/mld/siliconvalley/3868831.htm

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