Kelly Slone, director of the Medical Industry Group of the National Venture Capital Association (NVCA) posted an important article on October 7 on the NVCAccess blog, clearly calling out that the unintended consequences of FDA regulations have precipitated a full-blown crisis in medical innovation in the U.S. This crisis has already damaged America’s global competitiveness and slowed medical innovation in the U.S.  The report “revealed that US venture capitalists are reducing their investment in biotechnology and medical device companies and shifting focus overseas to Europe and Asia, primarily due to regulatory obstacles at the Food and Drug Administration.”

In related news, Mark Heesen, NVCA President, announced today that U.S. venture capital funds raised a total of  $1.7 billion, a 53 percent decrease in dollars from the third quarter of 2010 and the lowest amount since the third quarter of 2003.  Heesen observed in his blog post what he expects will become apparent when Q3 2011 VC investment statistics are released next week : “you can bet the total dollars invested into start-up companies will be a multiple of the amount raised.  It has been this way since 2008 when the industry began investing more than it was raising.  In fact, by the end of this quarter, the venture industry will have invested at least $20 billion more than it has raised in the last 3+ years.And just like a bubble, this imbalance is not sustainable.  Unless the industry begins to raise more money, we can expect investment levels to decline in the coming years in a significant way.”

You can download the full report: Vital Signs: The Threat to Investment in U.S. Medical Innovation and the Imperative of FDA Reform, from the NVCAccess blog.

Some key conclusions from the report follow:

U.S. venture capitalists have been and will continue to:
• Decrease their investment in biotechnology and medical device start-ups
• Reduce their concentration in critical therapeutic areas, and
• Shift focus away from the United States towards Europe and Asia
FDA regulatory challenges were identified as having the highest impact on these investment decisions.
We must act now or lose our leadership position in medical innovation, job creation and access to life-saving treatments in the United States. If the current situation is left unaddressed, the implications to U.S. patients and the economy are significant:
• Many promising medical therapies and technologies will not be funded and therefore will not reach the patients that need them.
• Those that are funded may not be brought to market in the United States first, or at all.
• An estimated funding loss of half a billion dollars over the next three years will cost America jobs at a time when we desperately need employment growth.
• The U.S. leadership position in medical innovation will be placed in further danger and economic growth with suffer.

For more factual background on the decades of neglect that have led us to where we are today, you may find the following links to presentation slides useful:

America’s Slipping Global Competitiveness– Implications for the Next Generation of American Emerging Growth Companies, keynote speech remarks delivered by Pascal Levensohn at ICAP Ocean Tomo conference, March 24, 2010, San Francisco

American Innovation in Crisis,Cybersecurity Applications and Technologies Conference for Homeland Security (CATCH) Conference, Walter E. Washington Convention Center Washington, D.C. Keynote Speech by Pascal Levensohn, March 4, 2009

Increasing numbers of professionals in a position to foment meaningful change in the capital markets are recognizing that structural issues underlie the IPO drought for emerging companies with market capitalizations below $1 billion.  This must become a widely held point of view before any meaningful structural reform can take place, setting aside the legislative delays we can continue to expect from the partisan divisions that have rendered our elected leaders ineffective.

I’ve made this structural argument for over three years on this blog and in public speeches.  Again, I urge readers to make their voices heard on this topic.  On November 24, 2008 I wrote A Case Study in the Unintended Consequences of Financial Regulation:  The Death of the U.S. Small Cap IPO? and invited anyone with constructive, practical ideas on how to revitalize IPO’s in the United States to contact me so that I could pass along their ideas to my colleagues at the National Venture Capital Association. In this post, I made a strong argument that structural market issues were the root cause of the death of the small capitalization IPO:

The lack of IPO’s in the U.S. has broad, negative implications for continued risk taking by U.S. venture capitalists. If we have no public market liquidity for emerging growth companies, there will be no next generation of American technology giants. The demise of the technology IPO has also contributed to the structural breakdown in the broader cycle of research and development that underlies the American innovation crisis…

This post followed my exposition of the argument that America would face an overall crisis in innovation, drawing on work by Judy Estrin and others, in September 2008: The Innovation Crisis Is Coming- Let’s Do Something About it Now!

Sadly, the veracity of these arguments is being proven over and over again, as the venture capital industry continues to shrink and the fallacy of an American jobless recovery becomes apparent.  Pointing to the success of several handfuls of social media companies as an index for the general health of innovation in the U.S. in 2011 is not statistically meaningful and irrelevant to the thousands of startups that are finding it impossible to reach the much greater critical mass necessary to access the public equity capital markets today.  To be clear, publicly traded household names that would not be able to go public today based on current IPO requirements include Dell, Intel, EMC, Yahoo!, Intuit, EA Sports, and many others.

In an article published on October 6, 2011 in Traders Magazine.Com, conference remarks by several leading international stock exchange professionals show that they are coming around to understanding the downside to small companies of a trading market infrastructure that treats unknown emerging public companies the same way as multi-billion dollar liquid securities:

“Though trading costs have gone down, that isn’t necessarily a good thing, according to Steve Wunsch, head of corporate initiatives at the ISE Stock Exchange. He said low trading costs have made it difficult for anyone to make money trading smaller names, thus drying up markets for smaller companies.”

…

Joseph Hall, a partner with the law firm of Davis Polk & Wardell, said the government could have caused part of the problem by repealing the Glass-Steagall Act’s separation of investment banks and commercial banks. That allowed a lot of small brokers to be bought up by big banks, reducing niche trading, he said.

Grant Thornton’s [David] Weild placed more of the blame on Reg NMS, which he said homogenized the markets to the detriment of new issuers. He said a one-size-fits-all market structure does not support smaller, newer companies.

The good news, Weild said, is that Washington seems to be paying attention. …

In my view, the bad news is that it’s taken three years since the global financial crisis erupted for us to get an increasing number of influential people to pay attention.  Meanwhile, millions of jobs have been lost, and innovation in America continues to suffer.

I never expected to have my first book published in China, much less in Mandarin, but that goes to show how much the world continues to change.  My contributions to this undergraduate textbook, Venture Capital: Theory & Practice, are the result of two important collaborations.  First, the body of collaborative work on corporate governance best practices that I have developed since 1999 with other venture capitalists and professional service providers to the venture industry; and, second, the direct collaboration on venture capital that resulted from meeting Professor Mannie Manhong Liu in the summer of 2007 at the  Symposium on Building the Financial System of the 21st Century between China and the US, sponsored by the Harvard Law School together with the CDRF (China Development Research Foundation) and PIFS (the Program on International Financial Systems).

Venture Capital started in China in 1985, when the first government-sponsored venture capital firm was established. The industry built slowly until a few years into the new century. In 2006, China’s total venture capital investment reached $1.78 B, becoming number two globally, next to the US; the US venture capital investment was $25.6B that year, accounting for 67.9% of the world total ($37.7b).  While China was far behind, accounting for about 4.7% of the total, nevertheless, China became number two and has kept that status ever since.

Venture Capital is a popular buzzword in China. Renmin University was among the first universities to create a venture capital major in the School of Finance and teach venture capital for undergraduates.  In recent years, many universities have followed, teaching venture capital as an elective course. In October 2010, our new textbook will become available.

Mannie and I share a strong interest in research in the field of venture capital and private equity. Mannie was working for Professor Josh Lerner at Harvard Business School before she returned to China to teach these subjects. The backbone for my contribution to our effort is the best practices work “for practitioners by practitioners” that I have developed in the area of venture capital through the multiple articles and three white papers that I’ve written.

Mannie was invited by a publisher in Beijing to write a textbook for undergraduate students in China; she in turn invited me to join her as the book’s co-author. Writing the book was a very intensive task, and both of us have worked on it for many months, with Mannie and her team translating my work and both of us discussing the context of the content for the Chinese audience.

Venture Capital: Theory and Practice, is in Chinese and is categorized as one of  “China’s National College Major Investment Textbook Series for the ‘Twelfth Five-Year Plan.’” The book has three parts and a total of 12 chapters. The Theory includes chapters on the venture capital concept, entrepreneurship, and a simple history; The Practice covers fundraising, business plan construction and analysis, investment due diligence, post investment monitoring and exit; and The Future emphasizes early stage investment, especially angel investment, as well as Cleantech VCs and socially responsible investment.  In the last chapter, Venture Capital in China, we explore the amazing development of China’s unique venture capital industry.

This textbook combines the strength of my Silicon Valley experiences as a venture capitalist and Mannie’s research as a professor, and it will help strengthen Chinese college-education programs in this particular field.  The book draws on and acknowledges important contributions from the members of the Working Group on Director Accountability and other experts in the field of venture capital.  I’ve donated all of my royalties from the book to the Society of Kauffman Fellows, which reported on the publication of this book in their July report.

Everybody agrees that, without meaningful job growth, America will not emerge from its current deep economic funk.  There is plenty of debate, however, over what drives that job creation engine in our country. I’ve recently read several interesting reports that touch on parts of the American job growth conundrum but do not tie them together.  Pooling some compelling statistics from these various sources, I believe that the following conclusions are correct and interrelated :

(1) Job growth drives GDP growth;

(2) New company formation drives job growth;

(3) New companies create the vast majority of new jobs after their Initial Public Offerings;

(4) Increased Initial Public Offerings are required to increase job growth;

(5) If the total annual number of Initial Public Offerings (IPO’s) in the U.S. does not exceed 500, which studies show is the level required to support 3% annual U.S. GDP growth, the U.S. will not generate the job growth necessary to rekindle meaningful sustainable GDP growth in the U.S.;

(6) The most efficient fuel for this IPO engine is venture capital.

The evidence:

(i) Startups are responsible for virtually all the new jobs created in the United States since 1977 (Source: Kauffman Foundation)

“The Importance of Startups in Job Creation and Job Destruction bases its findings on the Business Dynamics Statistics (BDS), a U.S. government dataset compiled by the U.S. Census Bureau. The BDS series tracks the annual number of new businesses (startups and new locations) from 1977 to 2005, and defines startups as firms younger than one year old.  The study reveals that, both on average and for all but seven years between 1977 and 2005, existing firms are net job destroyers, losing 1 million jobs net combined per year. By contrast, in their first year, new firms add an average of 3 million jobs.”

(ii) Clearing the backlog in the U.S. Patent Office (USPTO), could create 2.5mm new jobs over the next three years by contributing to startup formation.  Source:  New York Times Opinion article, Inventing Our Way Out of Joblessness by Hank Nothaft and Paul Michel, August 5, 2010 )

“1.2 million patent applications are currently awaiting examination by the USPTO …. each new issued patent creates  between 3 and 10 jobs.  Historic rates of patent grants suggest clearing the backlog could create 2.5mm jobs over the next three years.”

(iii) “Roughly 600,000 new businesses (that employ others) are started each year in the U.S.”  . . .

(iv) “Roughly 1,000 businesses receive their first VC funding each year . . .This means that only 1/16^th of 1% of new businesses obtain VC funding. . . .”

(v) “Since 1999, over 60% of IPOs have been VC-backed.  This is an extraordinary percentage considering that only 1/16^th of 1% of all companies are VC-backed.” “… it is highly unlikely that a company that does not take venture capital ends up going public. … Consistent with this success, venture capital has fueled many of the most successful start-ups of the last thirty years. … Four of the twenty companies with the largest market capitalization in the U.S.—Microsft, Apple, Google, Cisco—have been funded by venture capital.”

Source of (iii), (iv), and (v): “It Ain’t Broke: The Past, Present, and Future of Venture Capital”, by Professor Steven N. Kaplan of the University of Chicago Business School and Professor Josh Lerner of Harvard Business School.

(vi) Going back to the 1970’s it has been documented that 92% of the job growth in venture-backed companies occurs AFTER their IPO:

(vii) IPO’s currently account for 13% or LESS than all liquidity events for venture backed companies, down from 56% during the period from 1992 -2000:

(viii) The current IPO backlog and, more importantly, the poor aftermarket performance for the 85 IPOs priced in 2010 YTD, are symptomatic of a broken IPO pipeline:

According to David Weidner, author of the Wall Street Journal’s MarketBeat Blog, “Dealogic reports that the current 180-day backlog for IPOs now stands at 125 deals, a level three times higher than at the same point last year. The biggest industry waiting is computers and electronics with 23 deals seeking to raise as much as $4.8 billion, followed by finance, 19 deals, and healthcare, 17 deals. Private-equity and venture capital firms have been hard hit too. …While that door hasn’t closed, it has stalled, at least for the 125 issues waiting for the storm clouds to dissipate. So far, it’s been rough-going for most of the issuers who have taken the plunge. Of the 85 IPOs priced so far this year, only 28 are up. The total return for all issues combined is -1.97%, according to IPOScoop.com.”

(ix) The U.S. capital markets for listed equities have been in systemic decline since 1997, while every other major international equity market has been growing.  This is due to systemic regulatory failure and the unintended consequences of ill-conceived regulation that disproportionately negatively impacts startups.

For the detailed study behind (ix) and the two slides above, read “Market Structure Is Causing the IPO Crisis– And More”, by David Weild and Edward Kim, published by Grant Thornton in June 2010.

Conclusion:  If we don’t fix the IPO problem in America, we will not fix the job problem in America.  Venture capital is an essential ingredient to this recipe for success.  I can’t understand why our legislators and policymakers don’t understand this. If they did, there would be no higher legislative priority than promoting regulatory and tax reform to stimulate new capital formation and venture capital in the U.S.  The fact that Singapore, Brazil, India, China, Chile, the U.K., and other countries have figured this out should serve as strong corroborating evidence to the accuracy of this conclusion.

In a Wall Street Journal editorial, Otellini’s Lament, dated August 27,2010, the editor quotes Intel CEO Paul Otellini’s recent comments: “…Otellini . . . warned a technology forum this week that without a change in U.S. government policy ‘thenext big thing will not be invented here.  Jobs will not be created here.  And wealth will not accrue here.  Ultimately, we will face an inevitable erosion and shift of wealth– much like we are witnessing today in Europe.’”

I agree with Mr. Otellini, and it is no coincidence that my first book, Venture Capital: Theory & Practice, which I co-authored with Professor Mannie Manhong Liu of Renmin University of China, is in Chinese and is being published in China in October.  For more on the book, see my next blog post.