Doug Carlston - Software People. An Insider’s Look at the Personal Computer Software Industry

In November 1980, Microsoft signed a contract with IBM. Never eager to put all its eggs into the same basket, however, IBM had contracted with Digital Research, which had been working on an 8086 version of CP/M. But from the first day, PC-DOS, Microsoft’s operating system for the IBM PC (later joined by MS-DOS, a version for “IBM-compatible” machines), outsold CP/M by a wide margin. Microsoft’s operating system was ready before Digital Research’s and was therefore “bundled” (sold along with the hardware). It didn’t take long before “IBM compatible”—the magic words of the early 1980s—was nearly synonymous with “MS-DOS compatible.” By 1983, Microsoft was very close to knocking off Micropro for the number one position among microcomputer software companies. Digital Research was number four. But by 1984, Microsoft was almost at the top of the chart, soon to overtake MicroPro for the number one slot, while Digital was sinking.

Ex-homebrewers, computer science professors, game companies-turned-business software companies, and software entrepreneurs weren’t the only people to try and cash in on this market that IBM had so vastly enlarged. Increasingly, people who had big money to play with were considering the possibility of starting their own companies from scratch to capitalize on this lucrative market. Those people were none other than the venture capitalists.

At the beginning, the microcomputer industry was not only ignored by corporate America—it was totally unknown to the financial powers-that-be. But when teenagers began to build hundred-million-dollar companies in five years or so, the folks who were on the lookout for high-risk, high-gain investments began to get into the game. One of the earliest success stories was that of venture capitalist Arthur Rock, whose initial $75,000 investment in Apple Computer made him millions. It wasn’t long before such “vee-cees,” as they are sometimes called, turned their attention to software. Their sudden interest changed the industry: Most of the software companies that survived the 1984 shakeout (and several that didn’t) either had started with venture capital money or had taken venture capital investors on board.

Venture capital is not a new phenomenon—people who like to gamble on infant companies have always been attracted to new technologies. But the Tax Reform Acts of 1978 and 1981 made the institution a great deal more appealing to professional investors who were looking for tax breaks with fantastic upside potential.

The 1981 Act reduced the tax on long-term capital gains to a maximum of 40 percent of one’s ordinary tax rate. This is an extraordinary tax break, especially when you are talking about millions of dollars. Traditionally, most investors received long-term capital gains treatment by investing in the stock market. But the stock market didn’t perform very well in the 1970s. Financiers started looking for alternatives.

One alternative was to invest in venture capital funds. These funds are usually placed in small companies in very promising industries—companies such as those in high-technology industries, including aerospace, electronics, and computers. Typically, the fund investor identifies a company that is still small and strapped for cash as a likely comer and invests venture money that would enable the ambitious entrepreneur to expand his or her business. Ultimately, the fund would want to sell its interest and realize its gain, so venture capitalists try to ensure that they either sell their investments to a larger company or “go public” by offering their stock on the public market. Ideally, this is done once the company has passed through its most rapid growth.

If the company prospers, it is possible for a fund to reap ten or even one hundred times its original investment in just a few years. It is equally possible, however, that the company will falter somewhere along the way, in which case the fund might well lose every penny of its original investment. The real trick for an investor is to be smart enough and connected enough to the grapevine to be able to spot likely successes early enough to maximize his or her return.

It isn’t an easy business, and it never was. Good venture capitalists have to be able to separate form from substance. In the software game, where the product is not only intangible but unreadable to all but experts, this is especially true. Moreover, because they are generally too busy running their businesses, many of the most successful software entrepreneurs never have the time or interest to put together professional, polished business plans for an investor’s consideration. It is left to the venture investor to determine which young entrepreneur’s dream is likely to grow into an empire and which is likely to wither and die with most of the other startup companies.

But most venture capitalists don’t want people to come to them with plans anyway. They find it far more profitable to identify on their own the companies that they think would make good investments and then talk the owner of the company into taking the investment money. But in persuading the often reluctant entrepreneur to take the money, they also have to persuade him that his company’s current value is far lower than he may believe. No investment is a good one if the price isn’t right. The investor says he has one million dollars to invest. The entrepreneur says he has part of a company to sell. The key question is: How big a piece of the company’s future is worth a million dollars right now?

If they find the company early enough and are willing to spend enough, venture investors sometimes end up with a controlling interest in the company. When this happens, venture investors often decide that the company would be better off if the entrepreneur yielded the operational power over his or her company to a professional manager. In return, the entrepreneur receives a greater yield on the percentage of stock he or she still owns.

These deals aren’t particularly easy to figure out while they are happening, although brilliant investments and foolish decisions are abundantly clear in retrospect. What can sometimes complicate or even impede an investment arrangement in the first place, however, is the entrepreneur who suffers from a disease known as “entrepreneur’s syndrome.” This heady mix of boundless expectations and lack of restraints upon personal authority can lead to arrogance, which manifests itself in an inability either to delegate responsibility or to part with any portion of the ownership of one’s company. The first manifestation can destroy the management of small companies; the second can destroy the same company’s ability to become properly capitalized.

The best venture capitalists are true entrepreneurs in their own right. A mystique has grown up around successful investors like Don Valentine, Bill Hambrecht, and Ben Rosen, for it is no mean feat to pick the few winners from the thousands of ambitious men and women trying to bootstrap their kitchen-table operation into the next industrial giant. The best investors attract the most money to their funds, and this in turn leads (at least potentially) to the greatest investment profits. But the market became pretty crowded when software was hot, and then the venture capitalists deserted the field in droves when the shakeout began. Those venture capitalists who remain interested in software all seem to be chasing the same deals.

One of the great dangers in this investment game is that later-stage investors will buy into the company at a high price that reflects the fierce competition among the venture firms for good placement of their funds. Earlier investors will use these artificially high later prices to calculate growth in value of their own investments. These growth figures will be used, in turn, to attract further investors into their venture funds. But the price that a venture fund is willing to pay for a prepublic high-tech investment may actually be higher than the public, without such constraints upon its investment opportunities, would be willing to pay—the public may take the option of safer, lower growth investments such as bonds or mutual funds, while venture investors can’t go these safer routes. If that’s the case, the investors may be talking only with one another, and sooner or later the bubble may burst.