What is Venture Capital Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors (NVCA). Venture capital is an important source of equity for start-up companies. These portfolio companies that receive venture capital are thought to have excellent growth prospects. Start-up companies don't usually have the access to capital markets because they are private. Venture capitalists are one solution to financing high risk, but potentially high reward companies. Usually the investors receive a say in the company's management, they may be on the board, and they expect to receive returns 5-10 times their investment of up to 50 million dollars (Burk).
History of Venture Capital It is important to start out with the history of venture capital to see how it has grown as well as to show its ups and downs. It was thought to be developed in the years following WWII but it can actually be dated all the way back to partnerships in the Babylonian Code (Gompers). These Babylonian partnerships used gold or silver to finance caravans. The terms for were 12 years and 100% profits (Heise). Much later the first venture capital firm was established in 1946. Karl Compton, the MIT President, along with Georges Do riot, a Harvard Business School Professor, formed American Research and Development (ARD).
There were also local businesses leaders involved in the project. During the war, there were many new technologies developed as well as other innovations from MIT. About half of ARD's profits came from its investment in Digital Equipment Company in 1957. It had only invested $70, 000 but had grown in value to $355 million. A decade later, many other venture capital firms were formed. They were all structured as publicly traded closed-end funds as were ARD's.
Closed-end are mutual funds whose shares must be sold to other investors, instead of being redeemed from the issuing firm. In 1958, the first venture capital limited partnership was formed, Draper, Gaither, and Anderson. Others soon followed suit, but limited partnership remained the minority during 1960's and 1970's. The rest were either closed-end funds, or small business investment companies. During these years, the total annual venture funds were small and never exceeded a couple hundred million dollars. In the beginning pension funds were prohibited from investing in venture capital due to the high risk.
Because of this, most of the capital raised by individuals in the 70's. After a much needed change pension funds were allowed to be used, and subsequently accounted for more than half of all the contributions (Gompers). Later there was more change to come and in the late 1980's and early 1990's limited partnerships became the dominant form of the venture capital industry. Dot-Com Boom and Bust When the internet business started booming in the mid 1990's, people were seeing how the internet connected them to others around the world. This meant good advertising and mail-order businesses all at cheap prices. The venture capitalists saw the fast rise in valuation of these companies and moved faster and with less caution than usual, choosing to hedge the risk by starting many companies and letting the market decide which would succeed.
The low interest rates in 1998-1999 helped increase the startup capital amounts. When the internet companies became hot in the stock market, the boom peaked when the venture capitalists averaged a one-year return of 174% after investing $103 billion in 2000. A proportion of the new entrepreneurs were truly talented at business administration, sales, and growth, but the majority were just people with ideas, and didn't manage the capital very well. This majority formed the bulk of the 'dot-com' companies.
In early 2000, the Fed raised the interest rates 6 times. This caused the dot-com bubble to bust after the NASDAQ had more than doubled its value from the year before. By 2001, the dot-com industry had failed and trading stopped after going through all the venture capital without ever making a profit. As they ran out of capital, the companies were acquired or liquidated.
Two major companies that beat the odds were e Bay and Google which both are stronger than ever now. After the crisis only $36 billion was invested in venture funding the next year (NVCA). Even though there was more pressure than ever to contribute to venture capital, after the bust venture capitalists were more leery about investing. The VC's started being choosier on which companies to help, implementing due diligence more strictly. Due Diligence In order for a company to be considered, they must go through the process of due diligence. The venture capitalists and investors work hard to uncover every critical aspect of a company that they consider an investment opportunity.
Due diligence is "a legal obligation imposed on parties involved with the creation of prospectuses to use due diligence to ensure that they contain no material misstatements or omissions" (Camp). However, when it comes to venture capital, the rules are a bit different. These managers are not required to afford the VC's with the same level of information since they are private companies. Due to this asymmetric information, the venture capitalists must do their own lengthy research and become more informed about the company and industry. This is called venture capital due diligence.
This assessment includes the industry, market business concept, management team, the company's technology, products and markets, and the financial's. By being strict and fully assessing the potential investment, the capitalists are able to make better investments as well as improve their returns. There are many questions that should be asked when researching the potential investment. First, it is best to invest in a company that has a source close to the venture capitalists, someone that is well known and trusted. Next, they want to see the business plan in a clear and concise manner. VC's are interested in finding out who the existing investors are, who is the legal counsel, and accounting firm.
These are basic questions when screening. Other factors examined are feasibility. They want to know that the company has a sound product and a defined market. Also, scalability, is there a potential for growth? Next, the want to know that management is experienced. What is the market risk? Is there a viable exit strategy? As the questions get more in depth, many companies are weeded out.
Venture capitalists usually only select a few companies out of hundreds to start the due diligence research. Of this, only one from every three transactions will produce the expected return. Once they have become involved, if things go wrong, they cannot walk away by selling the investment because there is a limited secondary market. Therefore, they are required to spend time with the management, and possibly give more funds, in an attempt to help the company through difficult times. Sources of Capital Sources of venture capital include wealthy individual investors, investment banks, and other financial institutions that pool investments in venture-capital funds or limited partnerships. Investors must be patient as the capital invested in these ventures is illiquid.
The process that venture firms go through in seeking investment commitments from investors is called fund raising. The commitments of capital are raised from the investors during the formation of the fund. A venture firm will set out prospecting for investors with a target fund size. It will distribute a prospectus to potential investors and may take from several weeks to several months to raise the capital. The fund will seek commitments of capital from institutional investors, endowments, foundations and individuals who seek to invest part of their portfolio in opportunities with a higher risk. Because of the risk, length of investment and il liquidity involved in venture investing, and because the minimum commitment requirements are so high, average individuals do not have the capital to invest in ventures.
Venture capital funds can come in three main ways. First, they can come directly from venture capital funds, which raise money in the capital markets as independent entities. They can also come by institutions owning funds and making capital allocations to the activity. Lastly, they can come by a combination of direct market participation and internal allocation called semi-captives (Timmons).
It is also a good idea to have the company in close proximity to the venture capitalists so they can serve on the board and make periodic drop-ins. Venture capitalists are the general partners and control the funds. The limited partners are the investors. Limited partners are not allowed to be involved in the management, but they are allowed to see progress.
VC's are compensated the entire life of the fund, which is about 12 years on average. They usually receive annual fixed fee of about 2-3%, and variable compensation of a fraction of the funds profits of about 20%. The carried interest is the profit split of proceeds to the general partner. This is the general partners' fee for carrying the management responsibility plus all the liability and for providing the needed expertise to successfully manage the investment. In addition to these venture capitalist firms, there are smaller and bigger ways to acquire capital. Angels are individual venture investors.
They usually only work with hundreds of thousands of dollars being the first step of financing for small private companies outside the owners family and friends. When the portfolio company needs larger amounts of capital, they turn to the venture capital firms or the corporate venturing. This is the process by which large companies invest in smaller companies. Corporate venturing usually comes in the form of subsidiaries, which is usually done this for strategic reasons. A large corporation can benefit from a smaller corporation in which it can do business. Stages of Capital When a new venture starts up, it may need money in several stages of its life.
The first stage is called seed capital. This money is used for researching, and testing the product to see if it is going to be profitable. The start-up capital is the second stage. This is used for hiring people and purchasing equipment and inventories. As the firm expands, it may need more capital for modifying, or expanding the plant, which is provided by second stage finance. Management buy out is the finance granted to the firm's management and investors to acquire an existing product line or business.
As opposed to this is the Management buy-ins where funds are provided to managers outside the firm to buy into the firm with the support of venture capital investors. Lastly, mezzanine financing the final stage of financing before the company goes public. After going public, capital is raised by issuing and selling stock (Bartlett). Exiting the Company Depending on the investment focus and strategy of the venture firm, it will try to exit the investment in the established company within three to five years of the initial investment.
If it is a start-up company, the exiting will take up to 12 years. The most successful exits of venture investments occur through a merger or acquisition of the company. In a merger or acquisition, the venture firm will receive stock or cash from the acquiring company and the venture investor will distribute the proceeds from the sale to its limited partners. Another way to exit is the IPO.
In recent years technology IPO's have been in the limelight during the IPO boom of the last six years. At public offering, the venture firm is considered an insider and will receive stock in the company, but the firm is regulated and restricted in how that stock can be sold or liquidated for several years. Once this stock is freely tradable, usually after about two years, the venture fund will distribute this stock or cash to its limited partner investor who may then manage the public stock as a regular stock holding or may liquidate it. The venture capitalist cannot sell his shares right after the company goes public or it will show other would-be investors that the company is not very good.
VC's usually wait a minimum of six months before distribution. The VC's may also affect who holds the shares after the IPO. They have contracts with other investment banks in which they might want to have the shares to lower the risk of asymmetrical information. In the last twenty-five years, almost 3000 companies financed by venture funds have gone public.
An important factor in deciding when to go public is the valuation level of the publicly traded securities. The expertise of the venture firm in successfully exiting its investment will dictate the success of the exit for themselves and the owner of the company. The timing is very important. Some young venture capital firms are eager to take their portfolio companies public. They want to show how successful they are in a shorter period of time. This has come to be called grandstanding and it can ruin the reputation of the venture firm.
It is also proven that the venture-backed firms outperform the non-venture IPO's over a five-year period when the returns are weighted equally (Gompers). Future of Venture Capital There has been a big boom in the venture capital industry in the last two decades. The pool of U. S. venture capital funds has gown from less that $1 billion in the 1970's to over $60 billion in 1999. This number is likely to keep growing.
There have been many more pension funds invested in private equity. Also the experienced investors have increased their allocations to venture capital. Even though there has been major growth in the last few years, the industry wonders if it will sustain. As shown in previous years, there is a cycle of short-run shifts of supply of or demand for the capital. After the success and failure of the dot-com period, there were a few years of slow venture capital being released to portfolio companies. In 2004, however, the venture capital industry saw the highest profits since the dot-com days.
Now that the venture capitalists are doing better, but one wonders how long the happiness will last until the next cycle starts. There are many companies that have made it such as Digital Equipment Corporation, Apple, Federal Express, Sun Microsystems, Intel, Microsoft and Gene tech. Others have been less fortunate. Some have been liquidated and others sold to corporate acquirers. It is clear to see that most venture capital firms favor industries such as computer hardware, biotechnology, multi-media, and internet companies.
The venture capital industry is cyclical by nature. The future is always uncertain, but for now we will follow the cycle. As long as the venture fund industry stays strict on their rules and due diligence, they are sure to keep the cycle going. As the industry shows signs of recovery, venture capital is also becoming more global. Beyond the U. S.
, Europe and Israel, investors are also looking at opportunities in Asia, led by China and India. In 2004, about three-dozen VC's met for a summit to discuss the future of the industry. They are very optimistic about the future of venture capital funding. They say this is due to the fact that more investors are investing in venture capital, as well as the increase of IPO's (Raff a). Works Cited Bartlett, Joseph.
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