Venture capital
Venture capital is capital provided by outside investors for financing of new, growing or struggling businesses. Venture capital investments generally are high risk investments but offer the potential for above average returns. A
venture capitalist (VC) is a person who makes such investments. A
venture capital fund is a
pooled investment vehicle (often a
partnership) that primarily invests the
financial capital of third-party investors in enterprises that are too risky for the standard
capital markets or
bank loans. For aspiring entrepreneurs looking to locate and secure venture capital they have the option of seeking the support of a mentor capitalist. A mentor capitalist is an expert not only in acquiring capital but can also provide support and direction to early start-ups and seeds.
The VCs and their partners
Venture capital general partners (also known as "venture capitalists" or "VCs") may be former at firms similar to those which the partnership funds. Investors in venture capital funds (limited partners) are typically large institutions with large amounts of available capital, such as state and private
pension funds, university
endowments,
insurance companies, and
pooled investment vehicles. Other positions at venture capital firms include
venture partners and
entrepreneur-in-residence (EIR). Venture partners "bring in deals" and receive income only on deals they work on (as opposed to
general partners who receive income on all deals). EIRs are experts in a particular domain and perform
due dilligence on potential deals. EIRs are engaged by VC firms temporarily (six to 18 months) and are expected to develop and pitch startup ideas to their host firm (although neither party is bound to work with each other). Some EIR's move on to roles such as Chief Technology Officer (CTO) at a
portfolio company.
Fixed-lifetime funds
Most venture capital funds have a fixed life of ten years. This model was pioneered by some of the most successful funds in
Silicon Valley through the
1980s to invest in technological trends broadly but only during their period of ascendance, and to cut exposure to management and marketing risks of any individual firm or its product.
In such a fund, the investors have a fixed commitment to the fund that is "called down" by the VCs over time as the fund makes its investments. In a typical venture capital fund, the VCs receive an annual management fee equal to 2% of the committed capital to the fund and 20% of the net profits of the fund ("two and 20"). Because a fund may run out of capital prior to the end of its life, larger VCs usually have several overlapping funds at the same time; this lets the larger firm keep specialists in all stages of the development of firms almost constantly engaged. Smaller firms tend to thrive or fail with their initial industry contacts; by the time the fund cashes out, an entirely-new generation of technologies and people is ascending, whom the general partners may not know well, and so it is prudent to reassess and shift industries or personnel rather than attempt to simply invest more in the industry or people the partners already know.
How and why VCs invest
Investments by a venture capital fund can take the form of either
preferred stock equity or a combination of equity and
debt obligation, often with
convertible debt instruments that become equity if a certain level of risk is exceeded. The
common stock is often reserved by covenant for a future buyout, as VC investment criteria usually include a planned
exit event (an
IPO or
acquisition), normally within three to seven years.
In most cases, one or more general partners of the investing fund joins the
Board of Directors of the new venture, and will often help to recruit personnel to key management positions.
Venture capital is not suitable for many
entrepreneurs. Venture capitalists are very selective in deciding what to invest in; as a
rule of thumb, a fund invests only in about one in four hundred opportunities presented to it. They are most interested in ventures with high growth potential, as only such opportunities are likely capable of providing the financial returns and successful exit event within the required timeframe that venture capitalists expect. Because of such expectations, most venture funding goes into companies in the fast-growing
technology and
life sciences or
biotechnology fields. Because of these strict requirements, many entrepreneurs seek initial funding from
angel investors.
Winners and losers
Venture capitalists hope to be able to sell their stock, warrants, options, convertibles, or other forms of equity in three to seven years, at or after an exit event; this is referred to as harvesting. Venture capitalists know that not all their investments will pay off. The failure rate of investments can be high; anywhere from 20% to 90% of the enterprises funded fail to return the invested capital. When a venture fails, the entire funding by the venture capitalist is written off.
Many venture capitalists try to mitigate the risk of failure through diversification. They invest in companies in different industries and different countries so that the risk across their
portfolio is minimized. Others concentrate their investments in the industry that they are familiar with. In either case, they usually work on the assumption that for every ten investments they make, two will be failures, two will be successful, and six will be marginally successful. They expect that the two successes will pay for the time given to, and risk exposure of the other eight. In good times, the funds that do succeed may offer returns of 300 to 1000 percent to investors.
General
Georges Doriot is considered to be the father of venture capital industry. In 1946 he founded
American Research and Development Corporation (AR&D), whose biggest success was
Digital Equipment Corporation. When Digital Equipment went public in 1968 it provided AR&D with 101% annualized Return on Investment (ROI). ARD's $70,000 USD investment in Digital Corporation in 1959 had a market value of $37 million USD in 1968. The first venture-backed startup is generally considered to be
Fairchild Semiconductor, funded in
1959 by
Venrock Associates. Before
World War II, venture capital investments were primarily the domain of wealthy individuals and families. One of the first steps toward a professionally-managed venture capital industry was the passage of the
Small Business Investment Act of 1958. The 1958 Act authorized the U.S.
Small Business Administration (SBA) to license private "Small Business Investment Companies" (SBICs) to provide financing and management assistance to small entrepreneurial businesses in the United States. Passage of the Act addressed concerns raised in a Federal Reserve Board report to Congress that concluded that a major gap existed in the capital markets for long-term funding for growth-oriented small businesses. The goal of the SBIC program was, and still is, to stimulate the U.S. economy in general, and small businesses in particular, by facilitating the flow of capital to pioneering small concerns.
Venture capital is a phenomenon most closely associated with the
United States and technologically innovative ventures. Due to structural restrictions imposed on American banks in the
1930s there was no private
merchant banking industry in the United States, a situation that was quite unique in
developed nations. As late as the
1980s Lester Thurow, a noted
economist, decried the inability of the USA's financial regulation framework to support any merchant bank other than one that is run by the
United States Congress in the form of federally-funded projects. These, he argued, were massive in scale, but also politically motivated, too focused on
defense,
housing and such specialized technologies as
space exploration,
agriculture, and
aerospace. US investment banks were confined to handling large
M&A transactions, the issue of equity and debt
securities, and, often, the breakup of industrial concerns to access their
pension fund surplus or sell off
infrastructural capital for big gains.
Not only was the lax regulation of this situation very heavily criticized at the time, this
industrial policy was not in line with that of other industrialized rivals—notably
Germany and
Japan which at that time were gaining world markets in
automotive and
consumer electronics. There was a general feeling that the United States was in an economic decline.
However, those nations were also becoming somewhat more dependent on
central bank and elite academic judgement, rather than the more populist and consumerist way that priorities were set by government and private investors in the United States—a model that proved to have some advantages when the public's attention was strongly activated by the successful IPO of
Netscape and other Internet-related firms. This highlighted the nearly invisible role that
Silicon Valley had played in the sustaining of American economic innovation.
As of 2006 some of the most well known VC Firms are:
*
Kleiner, Perkins, Caufield and Byers *
Sequoia Capital*
Mayfield Fund *
Accel*
New Enterprise Associates*
Benchmark Capital*
Menlo Ventures*
Draper Fisher Jurvetson*
Highland Capital Partners*
The dotcom boom
Due almost entirely to the
dotcom boom, the late
1990s were a boom time for the globally-renowned VC firms on
Sand Hill Road in the
San Francisco, California area.
IPOs were taking truly irrational leaps, and access to "friends and family" shares was becoming a major determiner of who would benefit from any such IPO; the ordinary investor rarely got a chance to invest at the
strike price in this period.
The
NASDAQ crash and technology slump that started in March
2000, and the resulting catastrophic losses on overvalued, non-performing
startups, shook VC funds deeply. By
2003 many VCs were focused on writing off companies they funded just a few years earlier, and many funds were "under water"; that is, their portfolio companies were worth less than when invested in. Venture capital investors sought to reduce the large commitments they have made to venture capital funds. As of mid-
2003, the conventional wisdom was that the venture capital industry would shrink to about half its present capacity in the following few years. However, PricewaterhouseCoopers'
MoneyTree Survey shows total venture capital investments holding steady at 2003 levels through Q2 2005. The revival of an
Internet-driven environment (thanks to deals such as
eBay's purchase of
Skype, the
News Corporation's purchase of
MySpace, and the very-successful
Google IPO) has helped to revive the VC environment.
US firms have traditionally been the biggest participants in venture deals, but non-US venture investment is growing. Canadian companies are often linked to American firms, but have established many exceptional Venture Capital Funds. Europe has a large and growing number of active venture firms. Capital raised in the region in 2005, including
buy-out funds, exceeded €60bn, of which €12.6bn was specifically for venture investment. The
European Venture Capital Association includes a list of active firms and other statistics.
The
Indian Venture Capital Association estimates funding of
Indian companies will reach $1 billion in 2004.[
1] In China, venture funding more than doubled from $420 million in 2002 to almost $1 billion in 2003. For the first half of 2004, venture capital investment rose 32% from 2003.
For those who are new to the world of entrepreneurship and venture capitalism, or companies that are looking to reorganize their affairs they are often best advised to consider the support of a mentor capitalist. A mentor capitalist will not only provide guidance and support on how to acquire venture and angel investment support, the can help companies consolidate and implement direction. However, premiere venture capitalists such as
Sean Wise [
2] advocate that start-ups self finance until they reach a point where they can generate so much revenue prior to approaching an angel or venturist. This practice is called "bootstrapping".
*
Private equity*
Investment bank*
Business valuation*
Corporate Finance*
Open source funding*
List of venture capital firms*
List of Chicago Venture Capital Companies*
List of finance topics,
list of finance topics (alphabetical)*
Angel investor*
Venture Leasing*
Dragons' Den*
national venture capital association*
venture capital glossary*
Venture Capital in Germany*
Vulture Capital - salon.com article discussing novel about venture capital.
*
Interview with Andy Rachleff - An interview with famous VC Andy Rachleff, cofounder of Benchmark Capital.
