The downside of a corporate VC fund.

• Author: EDELSON, HARRY
• Position: Statistical Data Included

Otherwise sagacious chief executives saw nothing but riches when they formed in-house venture capital funds with unprecedented amounts of money. When all is said and done, most corporations will rue that move.

THE SIREN SONG of venture capital successes in the mid-1990s attracted a slew of corporations to the venture capital field in search of easy profits, a window on technology, and corporate synergy. Corporate operating capital was funneled into in-house venture capital arms at unprecedented rates in the past two years. The avalanche of funding by corporations into venture capital was precipitated by the enormous venture capital returns of recent years. Unfortunately, most corporations started their VC operations at the worst possible time. Moreover, an in-house corporate VC fund is rarely a good idea.

The Nasdaq Composite Index rose every year from 1995 to 1999, fueling enthusiasm for initial public offerings and creating great wealth for investors in venture capital. For five consecutive years beginning in 1995, the Index rose a minimum of 20% annually, culminating in an 85.6% increase in 1999 alone (a 130% increase to March 10, 2000, the date the Nasdaq Composite Index closed at an all time high). Emerging companies with little or no revenues (Cerent, Chromatis, Xros, Arrowpoint) were being acquired for billions of dollars by companies whose stocks were selling at exorbitant multiples of revenues, much less earnings. In early 2000, the Merrill Lynch Internet Index sold at more than 50 times revenues, not earnings.

Wall Street inflated the bubble, which would eventually burst, by launching more IPOs and raising more capital than ever before in history. Otherwise sagacious corporate chieftains saw nothing but riches in early stage investments and formed in-house VC funds with unprecedented amounts of capital. In 1999 alone, more than 50 corporations provided a minimum of $100 million each to new in-house VC arms. At least three companies committed to $1 billion funds (Accenture, EDS, and Intel). According to figures provided by Venture Economics, the reliable source of statistics for the venture capital industry, corporate venture capital activity stayed in a cyclical range of $85-542 million annually from 1980 until 1996 before escalating to $1.1 billion in 1997, $1.6 billion in 1998, $8.6 billion in 1999, and $16.5 billion in 2000. Despite warnings by some Wall Street pundits (and even a number of speeches by yours truly), the lemming's march towards financial immolation gathered steam in early 2000.

In March 2000, the bubble of excess valuation began to burst, eventually leading to a thunderous collapse, spreading destruction in its wake. The closing Nasdaq Composite Index peaked on March 10, 2000, at 5,048.42 before declining 63.5% to 1840.29 a little more than one year later on March 30, 2001. It has risen only modestly since. Do not be mislead by the difference between a series of annual gains of 20%-plus culminating in a 100%-plus gain and a subsequent loss of 63.5%. Look at it this way, a 100% loss wipes out everything; all of the gains ever made and even the base. A loss of 63.5% is pretty devastating. It brings us back to the levels of 1998. Internet and related telecommunication stocks...