What is Venture Capital?

November 23 2010 2 Commented

The following article appeared in the June 2010 issue of the Flathead Business Journal, but is no longer available online.

While wealthy businesspersons have been supporting start-up ventures for hundreds of years, by investing time and money as angel investors, the Venture Capital (VC) industry emerged as investors in new businesses after World War II.  The industry expanded rapidly with the passage of The Small Business Investment Act of 1958 and then after 1978 when the US Labor Department relaxed certain of the ERISA restrictions allowing corporate pension plans to invest in venture capital.

VC firms are limited partnerships in which a few general partners raise funds from passive limited partners, such as pension funds, foundation endowments and large corporate investors, and invest those funds in new ventures.  Venture capital funds range in size from $10s of millions to several hundred million dollars and invest in 20 or more start-up ventures during the decade-long life of the fund.  Typical investments by VCs today are rounds of $5 to $20 million in growth and later stage companies.  Prior to 2000, VCs often invested lesser amounts of funds in seed and start-up stage companies, but those investments represent a smaller fraction of deals done today.  VCs often invest in follow-on rounds of companies nurtured from start-up by angel investors.  VCs tend to invest in high-growth, high-tech firms in business sectors in which the VC general partners have substantial experience.  Since venture capital is a high risk asset class, limited partners expect substantial returns (greater than 15% per annum) from these investments.

VCs favor purchasing preferred shares of portfolio companies, because this structure provides minority investors with rights and controls usually unavailable to common shareholders.  While the percentage of ownership varies widely, VCs might purchase 1/3 ownership with an investment of $5 million. If more capital is required in multiple rounds of investment, the entrepreneurs’ ownership will continue to be diluted.

VC general partners are compensated in two ways for their efforts in managing funds:  (1) An annual administrative fee of 2% of the fund is charged to operate offices and pay salaries of principals and staff.  After a fund is fully invested and focused on managing ventures towards exits, this administrative fee is often reduced.  (2) The primary motivation for general partners is “carried interest.”  VC general partners earn 20% of the profits of the fund after capital is returned to investors.

Venture capitalists expect to harvest investments over the ten year life of their VC funds.  Typical exits are, as follows:

  • Dead bugs – A significant fraction of VC investments go out of business returning nothing to investors.  This might represent 20 – 40% of VC portfolio companies.  Very early stage companies tend to fail more frequently than later stage investments.
  • The Living Dead (Zombies) – Some VC-funded companies achieve positive cash flow but cannot grow sufficiently to justify the sale of the company to a larger public company.   These companies go side-ways, neither growing substantially nor winding down.  It is these investments that often represent the biggest problems to VCs.  The company has little or no value but closing it down only results in unemployed staff.
  • Initial Public Offerings (IPOs) – In earlier decades, going public was the favored vehicle for facilitating an eventual exit from VC funded companies, but the IPO market in the US has been stagnant for several years.  Until this market becomes more vibrant, IPOs as a significant exit strategy for VC investments will be limited.
  • Trade sales – The sale of venture-backed companies to larger public companies, usually for cash, is the most likely exit for successful new businesses today.  In most cases, this exit is likely to occur in eight to ten years after investment.

For the past 50 years, venture capital funded companies have been important components to the vibrant entrepreneurial economy in the US, creating a significant percentage of new jobs and wealth in America.

We are assembling a directory of venture capital firms with interest in investing in Montana companies which will be published this summer.  Click here.

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