Venture capital is a general term to describe financing for startup and early stage businesses as well as businesses in "turn around" situations. Venture capital investments generally are relatively high risk investments but may 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 typically too risky for typical equity investors or bank loans. A limited partner is a person or organization who invests capital in a venture capital fund for financial gain. A general partner is a venture capitalist who manages the fund and makes investments. Investments by a venture capital fund can take the form of either equity participation or a combination of equity participation and debt obligation -- often with convertible debt instruments that become equity if a certain level of risk is exceeded. In most cases, the venture capitalist becomes part owner of the new venture. Most investments are structured as preferred shares -- the common stock 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 case a venture fails, then the entire funding by the venture capitalist has to be written off.
Role of the venture capitalist
The roles performed by a venture capitalist are:
- directly providing funds for high risk, high return ventures
- arranging additional financing from other sources
- assessing and revising the proposed business model
- reformulating the overall strategy
- finding and hiring key managers
- finding supportive service companies and other business contacts
- firing existing managers where they think this is necessary
- buying-out existing partners (owners) where they think this is necessary
- providing operational and technical guidance to enhance overall business efficiency
- prepare the company for a potential exit (e.g. acquistion or initial public offering)
A great deal of specific expertise is usually involved, including negotiation and management and legal procedures required at different stages of a venture. This instructional capital tends to be hard to acquire, as it is rarely or not taught in any school. A sort of apprenticeship model often applies in venture capital businesses, with junior partners spending some time in the business before they assume a primary level of responsibility. Maintaining very extensive contacts in the industry in which they operate is also critical - a prime issue is intellectual capital and staying up to date.
Because the venture capitalist also tends to be a specialist in assessing pioneering ventures and their founders, the social capital, or contacts and connections, that they bring to this work is essential. Even a failed venture can be of some value if it lets the venture capitalist identify critical future contacts, exceptional technological or managerial talent, or open the door to communities of people engaged in technology transfer that may later yield more liquid benefits.
Types of venture capital
A new venture may need several infusions of cash from venture capitalists as the business progresses.
- The first round, referred to as seed capital, is obtained prior to company launch. It is for marketing research, concept testing, and alpha and beta testing.
- The second round, referred to as start-up capital, is for hiring staff, renting office space, completing product development, purchasing servers and other IT infrastructure, purchasing inventories, equipping the production system, and other activities involved in starting the business.
- As sales (and production) levels increase, additional rounds could be needed to modify the site, re-equip the production system, expand plant capacity, or purchase new facilities. These additional rounds are sometimes called second-stage financing or development capital.
- Mezzanine financing is the final round of financing before going public. Once a company's stock is publicly traded on a stock exchange, capital is raised by issuing and selling shares.
The terminology varies somewhat in different countries. In particular, in some countries where there is rarely or never any early financing, mezzanine finance is often referred to as venture capital. This becomes apparent to the new entrepreneur usually only after consulting an American source on what to do to sell a venture, and then being turned down by their Canadian, Argentinian, Australian, etc., venture firm, which is very often an arm of a conservative brokerage or bank, and has no interest in any financing of ventures that are primarily relying on unfamiliar assets. This seemed to ease somewhat during the 1990s during the dotcom boom, but it is widely reported that it is once again quite difficult to actually find seed or startup capital from venture capital firms anywhere other than on the US West Coast.
Venture capital fund operations
Venture capitalists are very selective in deciding what to invest in. A common figure is that they invest only in about one in four hundred ventures presented to them.
They are only interested in ventures with high growth potential. Only ventures with high growth potential are capable of providing the return that venture capitalists expect, and structure their businesses to expect. Because many businesses cannot create the growth required to have an exit event within the required timeframe, venture capital is not suitable for everyone.
Venture capitalists usually expect to be able to assign personnel to key management positions and also to obtain one or more seats on the company's board of directors. This is to put people in place, a phrase that has sometimes quite unfortunate implications as it was used in many accounting scandals to refer to a strategy of placing incompetent or easily bypassed individuals in positions of due diligence and formal legal responsibility, enabling others to rob stockholders blind. Only a tiny portion of venture capitalists, however, have been found liable in the large scale frauds that rocked American (mostly) finance in 2000 and 2001.
Venture capitalists expect to be able to sell their stock, warrants, options, convertibles, or other forms of equity in three to ten years: 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.
Many venture capitalists try to mitigate this problem through diversification. They invest in companies in different industries and different countries so that the systematic risk of their total portfolio is reduced. Others concentrate their investments in the industry that they are familiar with. In either case, they 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% to investors.
Venture capital partners (also known as "venture capitalists" or "VCs") may be former chief executives at firms similar to those which the partnership funds. Investors in venture capital funds 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.
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, 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. 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 stage 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 they do not know well, and so it is prudent to re-assess and shift industries or personnel rather than attempt to simply invest more in the industry or people it already knows.
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 investment 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 investment bank other than that 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, aerospace.
Investment banks were confined in general to large merger and acquisition activity, the issue of so-called "junk bonds", 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 greed was strongly activated by the 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.
Due almost entirely to this 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, has shaken VC funds deeply. In 2003, many VCs were focused on writing off companies they funded just a few years ago. At the same time, venture capital investors are seeking to reduce the large commitments they have made to venture capital funds. As of mid-2003, the conventional wisdom is that the venture capital industry will shrink to about half its present capacity in the next few years.
Meanwhile, investment banks of the more conventional sort have emerged due to some loosening of US financial regulations and the establishment of US bases for the largest global investment banks. It seems that the US model and the prevailing big investment bank model from the rest of the developed world have more or less merged. Given that almost all ventures ultimately merge, a more appropriate ending is hard to imagine.
US firms have traditionally been the biggest participants in venture deals, but non-US venture investment is growing. The Indian Venture Capital Association estimates funding of India companies will reach $1 billion in 2004. 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.
Venture capital firms
Examples of venture capital firms include: