Venture Capital

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 Doriot, 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 eBay 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 financials. 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