Mariana Mazzucato - The Value of Everything - Making and Taking in the Global Economy

As we saw in Chapter 5, another crucial success for the NVCA came when it persuaded the US government to relax the interpretation of the ‘prudent man’ investment rule (keeping pensions funds out of high-risk investments) to allow pension fund managers to invest up to 5 per cent of pension funds in riskier investments like VC ones. It meant that, from 1979 onwards, large sums of workers’ pensions savings flowed into VC funds – funds on which venture capitalists typically received a management fee of 2 per cent of total volume, as well as 20 per cent ‘carried interest’ of profits (i.e. the share of the profits that go to those managing the funds), like private equity. 13

In 1984, during a tour of Silicon Valley by the then French President, François Mitterrand, the discrepancy between the venture capitalists’ newfound bullishness and their actual achievements was picked up in an exchange between Paul Berg, one of the winners of the Nobel Prize in Chemistry that year, and Tom Perkins (the co-founder of Kleiner-Perkins) boasting about his sector’s role in biotech. Berg said: ‘Where were you guys in the ’50s and ’60s when all the funding had to be done in the basic science? Most of the discoveries that have fuelled [the industry] were created back then.’ 14For the venture capitalists, however, the prospect of astonishing profits now lay before them. Nothing summed up this new spirit of enterprise better than the upstart company that went public the same year: Apple. 15

Heads I Win, Tails You Lose

Apple Computer Company had been founded in a Californian garage in 1976. When it went public in 1980 it was the largest IPO (initial public offering) since the venerable fifty-three-year-old Ford Motor Company’s back in 1956. 16Apple turned into a legend overnight. It also blazed a trail: the IPO has since become the rite of passage for hundreds of hopeful high-tech start-ups, synonymous in the public mind with the success of Silicon Valley – and for very good reasons.

An IPO is the point at which expectation and potential come face to face with the realities of the marketplace. IPOs capture in one moment value generated over a long period, capitalizing the future profit potential of a business into a market price. For VC, in other words, timing is all.

By orchestrating this moment of alchemy – when the long and winding, always uncertain, usually collaborative, journey of innovation is crystallized into hard cash – venture capitalists, other investors, founders and early-stage employees have been able to reap extraordinary rewards. In that one moment, the ‘trapped equity’ – the sum of all the ingenuity, effort, risk-taking, collaboration and persistence that went into developing the new idea – is released and paid out to the flotation’s controllers, who may not have been the original innovators or risk takers.

IPOs are, first, a way for early investors to get their money out. The very possibility of an IPO encourages investment – although it has to be said that investors with one eye on the exit door and the other on the clock might not be ideal for nurturing a company to its potential. Second, IPOs can raise new capital for business expansion, which can be valuable in some sectors but less significant in others (like software), where the most important capital is human. Third, founders can realize the value of their ingenuity and sweat equity that has remained latent in the company. Fourth, employees, who may have been induced to leave secure jobs by the promise of equity in a risky venture, can realize the value of that equity – or at least see the possibility of doing so now that there is some liquidity in the company’s stock. This, indeed, was the primary motivation for Microsoft’s IPO in 1986, having awarded stock options to its employees since 1982. 17

To restate: investments in early-stage businesses are risky and most will fail. The volatility of returns to VC across the business cycle reveals the perils. 18Nonetheless, many venture capitalists have found themselves among the super-rich as a result of the success of high-tech firms in Silicon Valley. How has this happened? They have taken risks, of course – although mostly with other people’s money – which deserve to be rewarded. Yet the returns have come from investing in companies whose value was often created by decades of prior government investment. When the investment bets have paid off in a successful IPO or sale, the venture capitalists have benefited disproportionately from their favourable position as insiders. Then they have gained again from the increasingly favourable tax treatment of their capital gains within a tax system their industry has worked hard to shape.

The allocation of shares during an IPO favours insiders, including investment banks that underwrite the deal. The insiders have incentives to encourage hype about the IPO, setting the price low and limiting the stock’s availability to encourage the price to spike. As outsiders clamour to get their hands on the latest hot tech stock, insiders can sell at a large profit. 19It is as close to a ‘heads I win, tails you lose’ bet as it is possible to make.

All of which was writ large in the developing microelectronics industry of the 1980s, a fertile test bed for the evolution of the American VC industry. Previous post-war decades of US government investment meant that new companies in the sector could produce marketable products within the time horizons that VC investors demanded. Gradually the VC model migrated to other emerging sectors. The biopharmaceuticals industry, again, was built on massive US government investment, this time through the life sciences knowledge base, the National Institutes of Health (NIH), since 1938. Between 2009 and 2016, the NIH have been spending an average of $31.5 billion a year (in constant 2009 dollars), twice the level of the 1990s, and three times the level of the 1980s. In 2016 the amount totalled $32.3 billion. But in the biopharmaceutical sector the product cycles are much longer and more speculative than in microelectronics: less obviously a good fit with the VC financing model of exiting within five years. 20Along with firms like Amgen, Genzyme and Biogen, Genentech (now part of Roche) is one of only a small number of biopharmaceutical companies to keep their promise of producing a blockbuster drug (sales over $1 billion), of which the sector has generated only thirty in total. 21

Despite this patchy record, hundreds of biopharmaceutical startups have been able to raise finance through IPOs and continue in business for many years, often without the encumbrance of an actual product. These product-less IPOs (or PLIPOs) survive through R&D contracts with big pharmaceutical companies and through the speculative trading of their shares on NASDAQ, fermented by news about the success or failure of the latest clinical trial. Yet, if it has proved hard to make reliable money from the development of actual new blockbuster drugs, it seems that there have been plenty of ways to derive income by speculating about the possibilities of doing so. Nor has this unremarkable history of turning taxpayer-funded investments in life sciences into successful products prevented top executives in those companies being well rewarded in salaries and stock.

The classical economists would have had little time for the way in which the VC industry has extracted value by shifting money around rather than creating value: for them the point was to nurture the production of value rather than its simple circulation.

Yet the examples of the fortunes made in the 1990s and early 2000s by founders, venture capitalists, early-stage employees and senior executives from the Silicon Valley tech boom rippled out, resetting the norms and expectations for what leaders in more established sectors ought to be paid. Similarly, inflated expectations have also been built into the patent system, and more pervasively in innovative industries like ICT, biotech and pharmaceuticals. Patents, indeed, have become synonymous with value extraction.