Venture capital

Venture capital is a type of private equity capital typically provided by professional, outside investors to new, growth businesses. Generally made as cash in exchange for shares in the investee company, venture capital investments are usually high risk, 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 limited 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. Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies, or ventures, with limited operating history, who cannot raise funds through a debt issue. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity.

History

Beginnings of modern venture capital

Although many other similar investment mechanisms have exist in the past, General Georges Doriot is considered to be the father of the modern venture capital industry.

In 1946, Doriot founded American Research and Development Corporation (AR&DC), 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 1957 grew in value to $355 million USD.^{[citation needed]} It is commonly accepted that the first venture-backed startup is Fairchild Semiconductor, funded in 1959 by Venrock Associates. Venture capital investments, before World War II, were primarily the sphere of influence 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 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. 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. Facilitating the flow of capital through the economy up to the pioneering small concerns in order to stimulate the U.S. economy was and still is the main goal of the SBIC program today. ^{[citation needed]}

Generally, venture capital is closely associated with technologically innovative ventures and mostly in the United States.^[1] 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 differed from that of other industrialized rivals—notably Germany and Japan—which at that time were gaining ground in automotive and consumer electronics markets globally. However, those nations were also becoming somewhat more dependent on central bank and elite academic judgment, rather than the more diffuse way that priorities were set by government and private investors in the United States.

The growth of Silicon Valley

Slow Growth in 1960s & early 1970s, and the First Boom Year in 1978

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. 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. 1978 was the first big year for venture capital. The industry raised approximately $750 thousand in 1978.

Highs & Lows of the 1980s

In 1980, legislation made it possible for pension funds to invest in alternative assets classes such as venture capital firms. 1983 was the boom year - the stock market went through the roof and there were over 100 initial public offerings for the first time in U.S. history. That year was also the year that many of today's largest and most prominent firms were founded.

Due to the excess of IPOs and the inexperience of many venture capital fund managers, VC returns were very low through the 1980s. VC firms retrenched, working hard to make their portfolio companies successful. The work paid off and returns began climbing back up.

The dot com boom

The late 1990s were a boom time for the globally-renowned VC firms on Sand Hill Road in the San Francisco Bay Area. A number of large IPOs had taken place, and access to "friends and family" shares was becoming a major determiner of who would benefit from any such IPO; Common investors would have had no chance to invest at the strike price in this stage.^{[citation needed]}

The NASDAQ crash and technology slump that started in March 2000 shook some VC funds significantly by the resulting disastrous losses from overvalued and non-performing startups. By 2003 many firms were forced to write off companies they had funded just a few years earlier, and many funds were found "under water"; (the market value of their portfolio companies were less than the invested value) Venture capital investors sought to reduce the large commitments they had made to venture capital funds. By mid-2003, the venture capital industry would shrivel to about half its 2001 capacity. Nevertheless, PricewaterhouseCoopers' MoneyTree Survey shows that total venture capital investments hold steady at 2003 levels through the second quarter of 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.com, and the very successful Google.com and Salesforce.com IPOs) have helped to revive the VC environment with over $60billion in debt.

Venture capital fund operations

Roles within a VC firm

Venture capital general partners (also known in this case as "venture capitalists" or "VCs") are the executives in the firm, in other words the investment professionals. Typical career backgrounds vary, but many are former chief executives at firms similar to those which the partnership finances and other senior executives in technology companies.

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.

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 diligence 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.

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 "called down" by the VCs over time as the fund makes its investments. There are substantial penalities for a Limited Partner (or investor) that fails to participate in a capital call.

Compensation

In a typical venture capital fund, the general partners receive an annual management fee equal to 2% of the committed capital to the fund and 20% of the net profits (also known as "carried interest") of the fund; a so-called "two and 20" arrangement, comparable to the compensation arrangements for many hedge funds. Strong Limited Partner interest in top-tier venture firms has led to a general trend toward terms more favorable to the venture partnership, and many groups now have carried interest of 25-30% on their funds. 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.

Raising substantial venture capital

Venture capital is not generally suitable for all entrepreneurs. Venture capitalists are typically very selective in deciding what to invest in; as a rule of thumb, a fund may invest in as few as 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.

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 such as 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 VCs or angels. 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.^{[citation needed]}

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.

Venture capital and development

Venture capital can be used as a financial tool for development, within the range of SME finance, by playing a key role in business start-ups, existing small and medium enterprises (SME) and overall growth in developing economies. Venture capital acts most directly by being a source of job creation, facilitating access to finance for small and growing companies which otherwise would not qualify for receiving loans in a bank, and improving the corporate governance and accounting standards of the companies.

Venture capital is used as a tool for economic development in areas such as Latin America and the Caribbean.

Geographical differences

US firms have traditionally been the biggest participants in venture deals, but non-US venture investment is growing.

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 VC 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 in part as a result of a generous program of tax credits for scientific research and development. These tax credits are only available to Canadian controlled private companies (CCPCs). A CCPC must be incorporated in Canada. This creates a tension with many U.S.-based investors, since Canadian tax laws contain numerous irritants that have historically made exits from Canadian companies difficult for U.S.-based venture capital investors.

Canada also has a fairly unique form of venture capital generation in its Labour Sponsored Investment Funds (LSIF). These funds, also known as Labour Sponsored Venture Capital Corporations (LSVCC), are generally sponsored by labor unions and offer tax breaks from government to incite investors to purchase the funds. LSIFs are only permitted to invest in companies incorporated in Canada. However, innovative structures have been developed to permit LSIFs to direct in Canadian subsidiaries of corporations incorporated in jursidictions 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.^[2]

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.

Venture Capital Fund
The Reserve Bank of India, in regard to foreign exchange management act, frames the policy. The regulations of RBI for venture capital funds are that a SEBI registered venture capital fund investor can invest with the general permission of the RBI into Venture Capital Fund or Indian venture capital undertakings, according to the rules and regulations as specified by RBI notifications from time to time.

China

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

References

^ Venture Capital Industry Overview presentation for 1Q07, Dowjownes VentureSource based on data from Dow Jones VentureOne/Ernst&Young
^ Financial Times Article based on data published by Library House

Campbell, Katherine. Smarter Ventures: A Survivor's Guide to Venture Capital Through the New Cycle. Financial Times Management Press. ISBN 0-273-65403-9
VentureSource. Venture Capital Industry Overview, 1Q07. Dow Jones VentureSource.

External links

European Venture Capital Report
National Venture Capital Association
Venture Capital Glossary
Ricafe2 - A Research programme sponsored by the European Commission analysing venture capital.
Venture Capital News & Blog

[1] Venture Capital Industry Overview presentation for 1Q07, Dowjownes VentureSource based on data from Dow Jones VentureOne/Ernst&Young

[2] Financial Times Article based on data published by Library House

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