We've recently stressed that if we sell any stock from our Rule Breaker Portfolio, we must have a better place for the money. When we asked you to suggest some, TMF Community members made the cases for Qualcomm (Nasdaq: QCOM)JDS Uniphase (Nasdaq: JDSU), and Pre-Paid Legal Services (NYSE: PPD).

Fascinating companies, to be sure. But why such a short list? It used to be easier. In the days of easy venture capital and limitless investor enthusiasm for the new idea, it seemed that a path-breaking company went public every day. Now, capital markets are less enthusiastic.

Or to put it in the immortal words of Peter Seeger, made famous by Peter, Paul, and Mary, and herewith Foolishly twisted: 

Where have all the innovators gone?
Long time passing.
Where have all the Rule Breakers gone?
Long time ago.
Where have all the path-breakers gone?
Bleak capital markets nicked them, most every one.
Oh, when will they ever earn?
Oh, when will they ever earn?

While innovation is always happening, it requires money to move from dream to reality. Innovation's lifeblood is venture capital, which flows in bull markets and ebbs in bear ones. So while the little gray cells of many visionary brainiacs are dancing now, just as they did during the two great economic doldrums of our century -- the Great Depression and the post-1960s Go-Go years, it's tougher today for that intellectual capital to mate with monetary capital, which flees to safer returns. Venture capital has slowed, and many investors have turned to high-fat ice cream (or housing) instead of IPOs.

Venture non-capitalist
Numbers back this up. Venture capital (VC) research firm VentureOne tracks quarterly VC data, and both the number and dollar value of equity financings have fallen -- though the dollar value for the first six months of this year is still at a rate that would lead to higher numbers than any year from 1996 to 1998.

Equity Financings
    Number Change $Value  Change Nasdaq
2002 1059*        $10.5 bil.*     -25%*  
2001 2985   -51%   34.1     -63%  -21% 
2000 6046    34%   93.2      90%  -39% 
1999 4501    80%   49.0     177%   86%
1998 2502    15%   17.7      38%   40%
1997 2169    14%   12.8      30%   22%
1996 1898           9.9
*six months
[source: VentureOne]

Fewer IPOs, too
VentureOne's data for venture-backed IPOs -- new companies going public having grown with venture capital financing -- as opposed to spin-offs, such as Kraft (NYSE: KFT), or a demutualization of an insurance company, such as Prudential (NYSE: PRU) -- show the slowdown, too: 

Venture-Backed IPOs
    Number Change $Value  Change Nasdaq
2002  11*        $ 1.0 bil.*      -25%*
2001  21   -51%    1.7      -91%  -21%
2000 200    34%   18.8      - 3%  -39%
1999 248    80%   19.4      420%   86%
1998  68    15%    3.7      -19%   40%  
1997 121    14%    4.6      -47%   22%
1996 216           8.7
*six months
[source: VentureOne]

Broken down by quarters, you can really see the rush to get the IPOs out the door in Q3 2000 before VCs may have feared that door would shut:

7500                       x  x
7000                      
6500                                x
6000
5500
5000                  x  x    
4500
4000
3500
3000                             x
2500
2000
1500     x        x                    x
1000  x     x  
 500           x                          x
 250                                         x  x
     Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
         1998        1999        2000        2001
[source: VentureOne]

Yup, the pattern of capitalism is not nice and neat. Human behavior being what it is, and contrary to the academic view of the economic rational person, money flows towards new ideas en masse and away en masse, and sometimes that masse is pretty massive. Surely this chart shows that.

Faster bankruptcy rate
It appears that the spate of IPOs in 1999 and 2000 were of a lower average quality, too. Companies minted in 1999 are going bankrupt much faster than those before, and the 1999-2000 numbers are relatively worse than earlier years considering how little time has passed:

Year of First  Percentage
Financing Bankrupt Today 2001 3% 2000 18 1999 22 1998 14 1997 14 1996 14
1995 16
1994 17
1993 19
1992 14
[source: VentureOne]

The pain has not been distributed equally. Of the 1999 failures to date, 27% were in information technology, 20% in products and services (uh, what companies aren't in products and services?), and only 9% in health care. VentureOne's vice president of worldwide research, John Gabbert, said in a prepared statement, "In 1999, it was much harder for a health care company to attract financing, but many of those that succeeded have stood the test of time. The data really reinforces the theory of counter-cyclical investing: Companies that ultimately achieve liquidity often originate in business segments that are out of favor at the time."  

Maybe, maybe not.    

Case in point
People often assert that innovation continues in bear markets, even though the VC money and IPOs slow down. They say that it's a question of quality, and in tougher times, the best stuff still survives. But anyway you cut it, you still need money, and I'll bet that plenty of great innovation dies for lack of funds -- hence the Foolish refrain above, "When will they ever earn?" 

For an example, let's take two now-private companies whose technologies, if adopted, would turn the entire economics of wireless communication upside down. Sound like Rule Breakers to me. These companies come to mind because they would upend another company that several Community members recommended as a possible addition to the Rule Breaker Portfolio -- Qualcomm (Nasdaq: QCOM). Qualcomm was a little company flush with patents on its CDMA wireless technology. It bought the CDMA patents it didn't have and won patent suits against those who would assail its patent estate. CDMA has been ballyhooed as the inevitable future of high-speed wireless communications -- whether you call it 3G ("G" for generation) or slower-but-still-beats-dialup 2.5G.

Boosted by George Gilder and its own growing success in pushing adoption of CDMA, Qualcomm has gone from struggling outsider to established, with a breathtaking stock rise in 1999 and early 2000. You could make a decent case that today it's fairly valued somewhere in the low- to mid-20s, and it closed yesterday at $27.44. More importantly, whatever your view of the worldwide wireless standards war, it's safe to say that Qualcomm and CDMA will occupy a significant and profitable place. (You can debate all Qualcomm issues at The Motley Fool's very active Qualcomm discussion board!)

But meanwhile, the push to advance 3G networks has slowed. Huge telecoms in Europe amassed astonishing debt bidding for the spectrum licenses through which to offer high-speed wireless services to reluctant customers. What if innovators could offer a cheaper or more radical solution?

The Flarion call of 4G?
These two private companies are trying to do just that -- Flarion Technologies and IPWireless. One industry analyst estimates that telecoms could install Flarion's flash-OFDM (orthogonal frequency division multiplexing) equipment for $7 to $10 a subscriber, versus an estimated $40 to $70 for what today is touted as 3G. Because Flarion's technology is all IP -- Internet protocol -- and would promise more business for Cisco Systems (Nasdaq: CSCO) and other companies promoting all-IP networks, Cisco is a large investor in Flarion.

IPWireless presents a less radical but still cheaper solution. Flarion says IPWireless doesn't use a full IP method, but the response is that its adoption doesn't moot current equipment -- unlike Flarion's. Perhaps that's why IPWireless has raised twice the venture capital -- $120 million to Flarion's $60 million, according to Red Herring magazine.  

And Flarion's $60 million will only last through Q1 2003, according to company execs. To extend its lifespan, the company hopes that something will come from wireless communications provider Nextel (Nasdaq: NXTL) and defense contractor Northrop Grumman (NYSE: NOC), which are both evaluating the technology. The last thing Flarion wants is to be forced into an IPO in a lousy market and before it's ready to entice large institutional buyers. That desperation nets you way less -- ask Loudcloud, now Opsware (Nasdaq: OPSW) -- but it may be the only alternative to death or sale at unfavorable prices. At least you have something to tide you over while you hope for better times to sell more shares.

Today, former upstart Qualcomm is more likely a Rule Maker than Rule Breaker. Flarion Technologies and perhaps IPWireless are the more radical, rule-bustin' companies that might satisfy our investing criteria for this high-risk portfolio, but they are not public and may never be. We must be patient.

There are innovative companies going public, such as JetBlue (Nasdaq: JBLU), and there are already public companies innovating. But we must accept that a bear market slowdown in venture capital and IPO financing means fewer choices for now.     

Have a most Foolish week! Updated portfolio returns below.

Thirsty for thought-provoking stock ideas every month? Let The Motley Fool Select be your guide.

Because Tom Jacobs (TMF Tom9) finished third behind the other candidates in the recent Florida gubernatorial primary, he is pleased to announce that he will continue writing this column. At press time, he owned no shares in companies mentioned in this story. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.

Rule Breaker Portfolio Returns as of 9/23/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week      -5.65%**   -6.44%   --      -7.13%
Month     -3.56%**   -8.55%   --     -10.79%
Year     -30.92%**  -27.38%   --     -39.25%
CAGR 
using IRR*** since 8/4/94 +19.54% +7.62% +9.43% +6.31%

*Dividends added. Or, danger ahead. Whatever.

**Please keep in mind that these figures will be distorted for the RB Port for the short period around which we add any cash (see next note!). Since July 2001, we consider depositing $12,500 in new cash each quarter unless we have enough available for new investments without it. 

***Compound Annual Growth Rate using Internal Rate of Return. This performance measure is more meaningful than total return because we began adding cash occasionally in July 2001. In a total return calculation, or ((Current Value - All Cash Deposited)/All Cash Deposited), cash added would show up as returns. And that wouldn't be cricket!