How Venture Capital Works

The American economy is driven by invention and innovation. Additionally, they have a strong hold on the collective imagination of the country. The mainstream media is overflowing with tales of Silicon Valley entrepreneurs succeeding against all obstacles. The modern-day cowboy, the entrepreneur in these tales, is venturing out into uncharted industrial territory in a manner reminiscent of the early Americans’ exploration of the West. The venture capitalist, a shrewd sidekick who is willing to aid the hero through all the difficult moments in exchange for a cut of the action, is by his side.

Venture Capital Completes a Gap

Despite what the general public believes, venture capital is not a major factor in supporting basic innovation. In 1997, venture capitalists put in over $10 billion, yet just $600 million, or 6% of the total, went to start-ups. Furthermore, we calculate that R&D accounted for less than $1 billion of the venture capital pool as a whole. Most of that money was used to continue supporting initiatives that were started with far larger investments from firms ($133 billion) and governments ($63 billion).

The following phase of the innovation life cycle, when a business starts to market its invention, is where venture capital comes into play. According to our estimates, over 80% of venture capitalists’ investments are used to construct the infrastructure needed for the company to expand, with the majority going toward balance sheet items like fixed assets and working capital as well as expense investments in manufacturing, marketing, and sales.

Investment money for ventures is not long-term. Investing in a firm’s infrastructure and balance sheet is the objective here, either until the company grows to a size and reputation that allows it to be sold to a corporation or until institutional public stock markets can step in and offer liquidity. To put it simply, a venture capitalist purchases an initial investment in an entrepreneur’s concept, supports it for a little while, and then, with the assistance of an investment banker, walks away.

The structure and regulations of capital markets are what allow venture capital to have its specialty. There is frequently no alternative institution for someone with an idea or new technology to turn to. Bank interest rates are restricted by usury regulations, and the risks associated with starting a business typically warrant higher interest rates than those permitted by law. Consequently, lenders will only provide funding for a startup company if there are tangible assets available to secure the loan. Furthermore, many start-ups in the information-based economy of today have little tangible assets.

Furthermore, rules and procedures designed to safeguard public investors impose restrictions on both investment banks and public equity. In the past, a business needed assets of $10 million, revenues of around $15 million, and a consistent track record of profitability in order to be admitted to the public market. In context, the United States has over 5 million firms, of which less than 2% generate annual revenues of more than $10 million. Even though development-stage firm stocks were recently issued, lowering the IPO requirement, the funding window for businesses with less than $10 million in sales is still generally closed to entrepreneurs.

Venture capital bridges the gap between traditional, less expensive forms of finance available to continuing companies and sources of money for innovation (mostly corporations, government agencies, and the entrepreneur’s friends and family). To effectively fill that gap, the venture capital sector must offer enough return on investment to draw in private equity funds, competitive returns for its own investors, and enough upside potential to entrepreneurs to draw in top-tier concepts with high potential for profit. To put it simply, the problem is to continually generate higher returns on investments from business endeavors that are intrinsically hazardous.

Adequate Returns at a Reasonable Risk

Large organizations including pension funds, insurance companies, financial corporations, and university endowments are common investors in venture capital funds; each of these groups allocates a tiny portion of their overall assets to high-risk ventures. Throughout the course of the investment, they anticipate a return of between 25% and 35% annually. Venture capitalists have a great deal of flexibility because these investments make up such a small portion of the portfolios of institutional investors. These institutions are more likely to invest in a fund based on the firm’s overall performance history, the fund’s “story,” and their faith in the partners than on the particular investments.

How can venture capitalists satisfy the demands of their investors while taking reasonable risks? Their investing strategy and transaction structuring hold the key to the solution.

The profile of investments. A common misconception is that venture capitalists only fund worthy causes and individuals. In actuality, their investments are made in excellent industries, or ones that are more tolerant of competition than the overall market. For instance, the energy sector received close to 20% of venture capital investments in 1980. More recently, CD-ROMs, multimedia, telecommunications, and software firms have seen a sharp change in the capital flow from genetic engineering, specialized retailing, and computer hardware. Over 25% of payments are now made to the “space” on the internet. The targeted market in each case was developing quickly, and its capacity promised to be restricted in the following five years, so the seeming randomness of these transitions across technologies and industrial categories is deceiving. To place this in perspective, we calculate that, over the next five years, segments expected to increase at a rate of more than 15% annually account for fewer than 10% of all U.S. economic activity.