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Venture capital

Venture capital (also known as VC or Venture) is a type of private equity capital typically provided to immature, high-potential, growth companies in the interest of generating a return through an eventual realization event such as an IPO or trade sale of the company. Venture capital investments are generally made as cash in exchange for shares in the invested company.

Venture capital typically comes from institutional investors and high net worth individuals and is pooled together by dedicated investment firms.

A venture capitalist (also known as a VC) is a person or investment firm that makes venture investments, and these venture capitalists are expected to bring managerial and technical expertise as well as capital to their investments. A venture capital fund refers to a pooled investment vehicle (often an LP or LLC) that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. Venture capital is most attractive for new companies with limited operating history that are too small to raise capital in the public markets and are too immature to secure a bank loan or complete a debt offering. In exchange for the high risk that venture capitalists assume by investing in smaller and less mature companies, venture capitalists usually get significant control over company decisions, in addition to a significant portion of the company's ownership (and consequently value).

History

With few exceptions, private equity in the first half of the 20th century was the domain of wealthy individuals and families. The Vanderbilts, Whitneys, Rockefellers and Warburgs were notable investors in private companies in the first half of the century. In 1938, Laurance S. Rockefeller helped finance the creation of both Eastern Air Lines and Douglas Aircraft and the Rockefeller family had vast holdings in a variety of companies. Eric M. Warburg founded E.M. Warburg & Co. in 1938, which would ultimately become Warburg Pincus, with investments in both leveraged buyouts and venture capital.

Origins of modern private equity

Before World War II, venture capital investments (originally known as "development capital") were primarily the domain of wealthy individuals and families. It was not until after World War II that what is considered today to be true private equity investments began to emerge marked by the founding of the first two venture capital firms in 1946: American Research and Development Corporation. (ARDC) and J.H. Whitney & Company.

ARDC was founded by Georges Doriot, the "father of venture capitalism (former dean of Harvard Business School), with Ralph Flanders and Karl Compton (former president of MIT), to encourage private sector investments in businesses run by soldiers who were returning from World War II. ARDC's significance was primarily that it was the first institutional private equity investment firm that raised capital from sources other than wealthy families although it had several notable investment successes as well. ARDC is credited with the first major venture capital success story when its 1957 investment of $70,000 in Digital Equipment Corporation (DEC) would be valued at over $355 million after the company's initial public offering in 1968 (representing a return of over 500 times on its investment and an annualized rate of return of 101%). Former employees of ARDC went on to found several prominent venture capital firms including Greylock Partners (founded in 1965 by Charlie Waite and Bill Elfers) and Morgan, Holland Ventures, the predecessor of Flagship Ventures (founded in 1982 by James Morgan). ARDC continued investing until 1971 with the retirement of Doriot. In 1972, Doriot merged ARDC with Textron after having invested in over 150 companies.

J.H. Whitney & Company was founded by John Hay Whitney and his partner Benno Schmidt. Whitney had been investing since the 1930s, founding Pioneer Pictures in 1933 and acquiring a 15% interest in Technicolor Corporation with his cousin Cornelius Vanderbilt Whitney. By far Whitney's most famous investment was in Florida Foods Corporation. The company developed an innovative method for delivering nutrition to American soldiers, which later came to be known as Minute Maid orange juice and was sold to The Coca-Cola Company in 1960. J.H. Whitney & Company continues to make investments in leveraged buyout transactions and raised $750 million for its sixth institutional private equity fund in 2005.

Early venture capital and the growth of Silicon Valley

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 officially allowed the U.S. Small Business Administration (SBA) to license private "Small Business Investment Companies" (SBICs) to help the financing and management of the small entrepreneurial businesses in the United States.

During the 1960s and 1970s, venture capital firms focused their investment activity primarily on starting and expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical or data-processing technology. As a result, venture capital came to be almost synonymous with technology finance.

It is commonly noted that the first venture-backed startup is Fairchild Semiconductor (which produced the first commercially practical integrated circuit), funded in 1959 by what would later become Venrock Associates. Venrock was founded in 1969 by Laurance S. Rockefeller, the fourth of John D. Rockefeller's six children as a way to allow other Rockefeller children to develop exposure to venture capital investments.

It was also in the 1960s that the common form of private equity fund, still in use today, emerged. Private equity firms organized limited partnerships to hold investments in which the investment professionals served as general partner and the investors, who were passive limited partners, put up the capital. The compensation structure, still in use today, also emerged with limited partners paying an annual management fee of 1-2% and a carried interest typically representing up to 20% of the profits of the partnership.

The growth of the venture capital industry was fueled by the emergence of the independent investment firms on Sand Hill Road, beginning with Kleiner, Perkins, Caufield & Byers and Sequoia Capital in 1972. Located, in Menlo Park, CA, Kleiner Perkins, Sequoia and later venture capital firms would have access to the burgeoning technology industries in the area. By the early 1970s, there were many semiconductor companies based in the Santa Clara Valley as well as early computer firms using their devices and programming and service companies. Throughout the 1970s, a group of private equity firms, focused primarily on venture capital investments, would be founded that would become the model for later leveraged buyout and venture capital investment firms. In 1973, with the number of new venture capital firms increasing, leading venture capitalists formed the National Venture Capital Association (NVCA). The NVCA was to serve as the industry trade group for the venture capital industry. Venture capital firms suffered a temporary downturn in 1974, when the stock market crashed and investors were naturally wary of this new kind of investment fund.

It was not until 1978 that venture capital experienced its first major fundraising year, as the industry raised approximately $750 million. With the passage of the Employee Retirement Income Security Act (ERISA) in 1974, corporate pension funds were prohibited from holding certain risky investments including many investments in privately held companies. In 1978, the US Labor Department relaxed certain of the ERISA restrictions, under the "prudent man rule, thus allowing corporate pension funds to invest in the asset class and providing a major source of capital available to venture capitalists.

Venture capital in the 1980s

The public successes of the venture capital industry in the 1970s and early 1980s (e.g., Digital Equipment Corporation, Apple, Genentech) gave rise to a major proliferation of venture capital investment firms. From just a few dozen firms at the start of the decade, there were over 650 firms by the end of the 1980s, each searching for the next major "home run". While the number of firms multiplied, the capital managed by these firms increased only 11% from $28 billion to $31 billion over the course of the decade.

The growth the industry was hampered by sharply declining returns and certain venture firms began posting losses for the first time. In addition to the increased competition among firms, several other factors impacted returns. The market for initial public offerings cooled in the mid-1980s before collapsing after the stock market crash in 1987 and foreign corporations, particularly from Japan and Korea, flooded early stage companies with capital.

In response to the changing conditions, corporations that had sponsored in-house venture investment arms, including General Electric and Paine Webber either sold off or closed these venture capital units. Additionally, venture capital units within Chemical Bank and Continental Illinois National Bank, among others, began shifting their focus from funding early stage companies toward investments in more mature companies. Even industry founders J.H. Whitney & Company and Warburg Pincus began to transition toward leveraged buyouts and growth capital investments.

The venture capital boom and the Internet Bubble (1995 to 2000)

By the end of the 1980s, venture capital returns were relatively low, particularly in comparison with their emerging leveraged buyout cousins, due in part to the competition for hot startups, excess supply of IPOs and the inexperience of many venture capital fund managers. Growth in the venture capital industry remained limited through the 1980s and the first half of the 1990s increasing from $3 billion in 1983 to just over $4 billion more than a decade later in 1994.

After a shakeout of venture capital mangers, the more successful firms retrenched, focusing increasingly on improving operations at their portfolio companies rather than continuously making new investments. Results would begin to turn very attractive, successful and would ultimately generate the venture capital boom of the 1990s. Former Wharton Professor Andrew Metrick refers to these first 15 years of the modern venture capital industry beginning in 1980 as the "pre-boom period" in anticipation of the boom that would begin in 1995 and last through the bursting of the Internet bubble in 2000.

The late 1990s were a boom time for the venture capital, as firms on Sand Hill Road in Menlo Park and Silicon Valley benefited from a huge surge of interest in the nascent Internet and other computer technologies. Initial public offerings of stock for technology and other growth companies were in abundance and venture firms were reaping large windfalls.

The bursting of the Internet Bubble and the private equity crash (2000 to 2003)

The Nasdaq crash and technology slump that started in March 2000 shook virtually the entire venture capital industry as valuations for startup technology companies collapsed. Over the next two years, many venture firms had been forced to write-off their large proportions of their investments and many funds were significantly "under water" (the values of the fund's investments were below the amount of capital invested). Venture capital investors sought to reduce size of commitments they had made to venture capital funds and in numerous instances, investors sought to unload existing commitments for cents on the dollar in the secondary market. By mid-2003, the venture capital industry had shriveled to about half its 2001 capacity. Nevertheless, PricewaterhouseCoopers' MoneyTree Survey shows that total venture capital investments held steady at 2003 levels through the second quarter of 2005.

Although the post-boom years represent just a small fraction of the peak levels of venture investment reached in 2000, they still represent an increase over the levels of investment from 1980 through 1995. As a percentage of GDP, venture investment was 0.058% percent in 1994, peaked at 1.087% (nearly 19x the 1994 level) in 2000 and ranged from 0.164% to 0.182 % in 2003 and 2004. The revival of an Internet-driven environment in 2004 through 2007 helped to revive the venture capital environment. However, as a percentage of the overall private equity market, venture capital has still not reached its mid-1990s level, let alone its peak in 2000.

However, venture capital funds, which were responsible for much of the fundraising volume in 2000 (the height of the dot-com bubble), raised only $25.1 billion in 2006, a 2% percent decline from 2005 and a significant decline from its peak.

Venture capital firms and funds

Structure of venture capital firms

Venture capital firms are typically structured as partnerships, the general partners of which serve as the managers of the firm and will serve as investment advisors to the venture capital funds raised. Venture capital firms in the United States may also be structured as limited liability companies, in which case the firm's managers are known as managing members. Investors in venture capital funds are known as limited partners. This constituency comprises both high net worth individuals and institutions with large amounts of available capital, such as state and private pension funds, university financial endowments, foundations, insurance companies, and pooled investment vehicles, called fund of funds or mutual funds.

Roles within venture capital firms

Within the venture capital industry, the general partners and other investment professionals of the venture capital firm are often referred to as "venture capitalists" or "VCs". Typical career backgrounds vary, but broadly speaking venture capitalists come from either an operational or a finance background. Venture capitalists with an operational background tend to be former founders or executives of companies similar to those which the partnership finances or will have served as management consultants. Venture capitalists with finance backgrounds tend to have investment banking or other corporate finance experience.

Although the titles are not entirely uniform from firm to firm, other positions at venture capital firms include:

  • Venture partners - Venture partners are expected to source potential investment opportunities ("bring in deals") and typically are compensated only for those deals with which they are involved.
  • Entrepreneur-in-residence (EIR) - EIRs are experts in a particular domain and perform due diligence on potential deals. EIRs are engaged by venture capital 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 executive positions within a portfolio company.
  • Principal - This is a mid-level investment professional position, and often considered a "partner-track" position. Principals will have been promoted from a senior associate position or who have commensurate experience in another field such as investment banking or management consulting.
  • Associate - This is typically the most junior apprentice position within a venture capital firm. After a few successful years, an associate may move up to the "senior associate" position and potentially principal and beyond. Associates will often have worked for 1-2 years in another field such as investment banking or management consulting.

Structure of the funds

Most venture capital funds have a fixed life of 10 years, with the possibility of a few years of extensions to allow for private companies still seeking liquidity. The investing cycle for most funds is generally three to five years, after which the focus is managing and making follow-on investments in an existing portfolio. This model was pioneered by 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 initially unfunded and subsequently "called down" by the venture capital fund over time as the fund makes its investments. There are substantial penalties for a Limited Partner (or investor) that fails to participate in a capital call.

Compensation

Venture capitalists are compensated through a combination of management fees and carried interest (often referred to as a "two and 20" arrangement:

  • Management fees – an annual payment made by the investors in the fund to the fund's manager to pay for the private equity firm's investment operations. In a typical venture capital fund, the general partners receive an annual management fee equal to up to 2% of the committed capital.
  • Carried interest - a share of the profits of the fund (typically 20%), paid to the private equity fund’s management company as a performance incentive. The remaining 80% of the profits are paid to the fund's investors Strong Limited Partner interest in top-tier venture firms has led to a general trend toward terms more favorable to the venture partnership, and certain groups are able to command carried interest of 25-30% on their funds.

Because a fund may run out of capital prior to the end of its life, larger venture capital firms 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.

Venture capital funding

Venture capitalists are typically very selective in deciding what to invest in; as a rule of thumb, a fund may invest in one in four hundred opportunities presented to it. Funds are most interested in ventures with exceptionally high growth potential, as only such opportunities are likely capable of providing the financial returns and successful exit event within the required timeframe (typically 3-7 years) that venture capitalists expect.

Because investments are illiquid and require 3-7 years to harvest, venture capitalists are expected to carry out detailed due diligence prior to investment. Venture capitalists also are expected to nurture the companies in which they invest, in order to increase the likelihood of reaching a IPO stage when valuations are favourable. Venture capitalists typically assist at four stages in the company's development:



There are typically six stages of financing offered in Venture Capital, that roughly correspond to these stages of a companies development.

  • Seed Money: Low level financing needed to prove a new idea (Often provided by "angel investors")
  • Start-up: Early stage firms that need funding for expenses associated with marketing and product development
  • First-Round: Early sales and manufacturing funds
  • Second-Round: Working capital for early stage companies that are selling product, but not yet turning a profit
  • Third-Round: Also called Mezzanine financing, this is expansion money for a newly profitable company
  • Fourth-Round: Also called bridge financing, 4th round is intended to finance the going public process

Because there are no public exchanges listing their securities, private companies meet venture capital firms and other private equity investors in several ways, including warm referrals from the investors' trusted sources and other business contacts; investor conferences and symposia; and summits where companies pitch directly to investor groups in face-to-face meetings, including a variant know as "Speed Venturing", which is akin to speed-dating for capital, where the investor decides within 10 minutes whether s/he wants a follow-up meeting. Mass High Tech, September 5, 2008

This need for high returns makes venture funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. That is most commonly the case for intangible assets such as software, and other intellectual property, whose value is unproven. In turn this explains why venture capital is most prevalent in the fast-growing technology and life sciences or biotechnology fields.

If a company does have the qualities venture capitalists seek including a solid business plan, a good management team, investment and passion from the founders, a good potential to exit the investment before the end of their funding cycle, and target minimum returns in excess of 40% per year, it will find it easier to raise venture capital.

Main alternatives to venture capital

Because of the strict requirements venture capitalists have for potential investments, many entrepreneurs seek initial funding from angel investors, who may be more willing to invest in highly speculative opportunities, or may have a prior relationship with the entrepreneur.

Furthermore, many venture capital firms will only seriously evaluate an investment in a start-up otherwise unknown to them if the company can prove at least some of its claims about the technology and/or market potential for its product or services. To achieve this, or even just to avoid the dilutive effects of receiving funding before such claims are proven, many start-ups seek to self-finance until they reach a point where they can credibly approach outside capital providers such as venture capitalists or angel investors. This practice is called "bootstrapping".

There has been some debate since the dot com boom that a "funding gap" has developed between the friends and family investments typically in the $0 to $250,000 range and the amounts that most Venture Capital Funds prefer to invest between $1 to $2M. This funding gap may be accentuated by the fact that some successful Venture Capital funds have been drawn to raise ever-larger funds, requiring them to search for correspondingly larger investment opportunities. This 'gap' is often filled by angel investors as well as equity investment companies who specialize in investments in startups from the range of $250,000 to $1M. The National Venture Capital association estimates that the latter now invest more than $30 billion a year in the USA in contrast to the $20 billion a year invested by organized Venture Capital funds.

In industries where assets can be securitized effectively because they reliably generate future revenue streams or have a good potential for resale in case of foreclosure, businesses may more cheaply be able to raise debt to finance their growth. Good examples would include asset-intensive extractive industries such as mining, or manufacturing industries. Offshore funding is provided via specialist venture capital trusts which seek to utilise securitization in structuring hybrid multi market transactions via an SPV (special purpose vehicle): a corporate entity that is designed solely for the purpose of the financing.

In addition to traditional venture capital and angel networks, groups have emerged which allow groups of small investors or entrepreneurs themselves to compete in a privatized business plan competition where the group itself serves as the investor through a democratic process.

Geographical differences

Venture capital, as an industry, originated in the United States and American firms have traditionally been the largest participants in venture deals and the bulk of venture capital has been deployed in American companies. However, increasingly, non-US venture investment is growing and the number and size of non-US venture capitalists have been expanding.

Venture capital has been used as a tool for economic development in a variety of developing regions. In many of these regions, with less developed financial sectors, venture capital plays a role in facilitating access to finance for small and medium enterprises (SMEs), which in most cases would not qualify for receiving bank loans.

United States

Venture capitalists invested some $6.6 billion in 797 deals in U.S. during the third quarter of 2006, according to the MoneyTree Report by PricewaterhouseCoopers and the National Venture Capital Association based on data by Thomson Financial.

A recent National Venture Capital Association survey found that majority (69%) of venture capitalists predict that venture investments in U.S. will level between $20-29 billion in 2007.

Canada

Canadian technology companies have attracted interest from the global venture capital community as a result, in part, of generous tax incentive through the Scientific Research and Experimental Development (SR&ED) investment tax credit program. The basic incentive available to any Canadian corporation performing R&D is a non-refundable tax credit that is equal to 20% of "qualifying" R&D expenditures (labour, material, R&D contracts, and R&D equipment). An enhanced 35% refundable tax credit of available to certain (i.e. small) Canadian-controlled private corporations (CCPCs). Because the CCPC rules require a minimum of 50% Canadian ownership in the company performing R&D, foreign investors who would like to benefit from the larger 35% tax credit must accept minority position in the company - which might not be desirable. The SR&ED program does not restrict the export of any technology or intellectual property that may have been developed with the benefit of SR&ED tax incentives. Canada also has a fairly unique form of venture capital generation in its Labour Sponsored Venture Capital Corporations (LSVCC). These funds, also known as Retail Venture Capital or Labour Sponsored Investment Funds (LSIF), are generally sponsored by labor unions and offer tax breaks from government to encourage retail investors to purchase the funds. Generally, these Retail Venture Capital funds only invest in companies where the majority of employees are in Canada. However, innovative structures have been developed to permit LSVCCs to direct in Canadian subsidiaries of corporations incorporated in jurisdictions outside of Canada.

Europe

Europe has a large and growing number of active venture firms. Capital raised in the region in 2005, including buy-out funds, exceeded €60mn, of which €12.6mn was specifically for venture investment. The European Venture Capital Association includes a list of active firms and other statistics. In 2006 the top three countries receiving the most venture capital investments were the United Kingdom (515 minority stakes sold for €1.78bn), France (195 deals worth €875m), and Germany (207 deals worth €428m) according to data gathered by Library House.

European venture capital investment in the second quarter of 2007 rose 5% to 1.14 billion Euros from the first quarter. However, due to bigger sized deals in early stage investments, the number of deals was down 20% to 213. The second quarter venture capital investment results were significant in terms of early-round investment, where as much as 600 million Euros (about 42.8% of the total capital) were invested in 126 early round deals (which comprised more than half of the total number of deals).

India

The investment of capitalists in Indian industries in the first half of 2006 is $3 billion and is expected to reach $6.5 billion at the end of the year. Most VC firms in India are either divisions or subsidiaries of Silicon Valley funds. They are primarily centered in Bangalore and Mumbai. Some VCs also operate from Delhi and other parts of the National Capital Region.

China

In China, venture funding more than doubled from $420,000 in 2002 to almost $1 million in 2003. For the first half of 2004, venture capital investment rose 32% from 2003. By 2005, led by a wave of successful IPOs on the NASDAQ and revised government regulations, China-dedicated funds raised US$4 million in committed capital.

Vietnam

In Vietnam, venture funding has been increasing rapidly as Vietnamese overseas returnees and Vietnamese ex-managers of multinational companies increasingly establish new companies with ambitious growth plans. Firms such as Mekong Ventures, IDG Vietnam Ventures and DFJ-VinaCapital have pioneered investments in seed-stage and start-up stage companies in Vietnam. The $20 Million Challenge is Vietnam's first business plan contest for local entrepreneurs.

Italy

Private equity in Italy was 4.2 billion euro in 2007.

Confidential information

Unlike public companies, information regarding an entrepreneur's business is typically confidential and proprietary. As part of the due diligence process, most venture capitalists will require significant detail with respect to a company's business plan. Entrepreneurs must remain vigilant about sharing information with venture capitalists that are investors in their competitors. Most venture capitalists treat information confidentially, however, as a matter of business practice, do not typically enter into Non Disclosure Agreements because of the potential liability issues those agreements entail. Entrepreneurs are typically well-advised to protect truly proprietary intellectual property.

Limited partners of venture capital firms typically have access only to limited amounts of information with respect to the individual portfolio companies in which they are invested and are typically bound by confidentiality provisions in the fund's limited partnership agreement.

Popular culture

Robert von Goeben and Kathryn Siegler produced a comic strip called The VC between the years 1997-2000 that parodied the industry, often by showing humorous exchanges between venture capitalists and entrepreneurs. Von Goeben was a partner in Redleaf Venture Management when he began writing the strip.

Mark Coggins' 2002 novel Vulture Capital features a venture capitalist protagonist who investigates the disappearance of the chief scientist in a biotech firm in which he has invested. Coggins also worked in the industry and was co-founder of a dot-com startup.

Drawing on his experience as reporter covering technology for the New York Times, Matt Richtel produced the 2007 novel Hooked, in which the actions of the main character's deceased girlfriend, a Silicon Valley venture capitalist, play a key role in the plot.

See also

References

  • Campbell, Katherine. Smarter Ventures: A Survivor's Guide to Venture Capital Through the New Cycle. Financial Times Management Press. ISBN 0-273-65403-9
  • Gompers, Paul, and Josh Lerner, "The Venture Capital Cycle", 2nd ed., MIT press, 2004.
  • Ortgiese, Jens: Value Added by Venture Capital Firms. Eul publishing, 2007, ISBN 978-3899366211
  • What Are Venture Capitalists Looking For in an RFID Start-up?, RFID Radio
  • Introduction to Venture Capital and Private Equity Finance, The Encyclopedia of Private Equity
  • VentureSource. Venture Capital Industry Overview, 1Q07. Dow Jones VentureSource.
  • Hervé Lebret, "Start-Up : what we may still learn from Silicon Valley", CreateSpace, 2007, ISBN 1-434-82006-8
  • Josephson, Matthew, "The Money Lords; the great finance capitalists, 1925-1950", New York, Weybright and Talley, 1972.


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