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What Is Venture Capital?

The word venture suggests that this type of capital involves a degree of risk and even something of a gamble. Specifically, as defined by Helen Soussou, "the venture capital industry supplies capital and other resources to entrepreneurs in business with high growth potential in hopes of achieving a high rate of return on invested funds."5 The whole investing process involves many stages, which are represented in Exhibit 5.3. Throughout the investing process, venture capital firms seek to add value in several ways: identifying and evaluating business opportunities, including management, entry, or growth strategies; negotiating and closing the investment; tracking and coaching the company; providing technical and management assistance; and attracting additional capital, directors, management, suppliers, and other key stakeholders and resources. The process begins with the conception of a target invest­ment opportunity or class of opportunities, which leads to a written proposal or prospectus to raise a venture capital fund. Once the money is raised, the value creation process moves from generating deals to crafting and executing harvest strategies and back to raising another fund. The process usually takes up to ten years to unfold, but excep­tions in both directions often occur.

The Venture Capital Industry Pre-1990

Although the roots of venture capital can be traced from investments made by wealthy families in the 1920s and 1930s, most industry observers credit Ralph E. Flanders, then president of the Federal Reserve Bank of Boston, with the idea. In 1946, Flanders joined a top-ranked team to found American Research and Development Corpora­tion, the first firm, as opposed to individuals, to provide risk capital for new and rapidly growing firms (most of which were manufacturing and technology oriented).

Despite the success of American Research and Development, the venture capital industry did not experience a growth spurt until the 1980s, when the industry "went ballistic." See Exhibit 5.4 for the U. S. capital commitments between 1969 and 2003. Before 1980, venture capital investing activities could be called dormant; just $460 million was invested in 375 companies in 1979. By 1987, the industry had bal­looned to more than 700 venture capital firms, which invested $3.94 billion in 1,729 portfolio companies. The sleepy, cottage industry of the 1970s was transformed into a vibrant, at times frenetic, occasion­ally myopic, and dynamic market for private risk and equity capital in the 1980s. According to Michael Vachon, "After shrinking by an aver­age of 25 percent a year for four years, new venture capital raised in 1992 more than doubled over 1991."10 Yet industry observers attributed the increase to "repeat fund raisers assembling partnerships of more than $100 million."11

Exhibit 5.3 Classic Venture Capital Investing Process

rljro CO'lCOptiOi"

target Investment enpoi

Raise capital 'c< investment

Generate deal i'ow New 2nd ycjng companies *vrh h■ g;i potent:

Scx'S'i and evaijerte dea'S

/aijdt'ci and negotiat'en Structure deals

5-:o 10-year

win clew

/>dd vs.lo via

Jira:egy cevslopmert

\ctive boa'd membership

*:tr"act cu:side expertise

tlract later 'ound investor

•itract ciher stakeholders, management

;'ov!de ccnlacls access to into, oeoole, institutions:

C'df: and execute exit st'ateg.es■ PO

jquicaiion A'liances

Source: William D. Bygrave and Jeffry A. Timmons, Venture Capita! at the Crossroads (Boston: Harvard Business School Press, 1992), Figure 1-4.

The Booming 1990s

As one can see in Exhibit 5.5, the industry experienced an eightfold increase in the 1990s. While the absolute dollars committed and invested by 2000 were huge, the rate of increase in the 1980s was much greater, $1 billion in 1979 and $3 1 billion in 1989.

By 2001, not only had the commitments changed, but a new struc­ture was also emerging, increasingly specialized and focused. Exhibit 5.6 summarizes some of the important changes in the industry, which have implications for small business owners seeking money and for those investing it. Several major structural trends that emerged at the end of the 1980s continued through the 1990s: (1) The average fund size grew larger and larger; megafunds in excess of $500 million accounted for nearly 80 percent of all capital under management. High-performing funds like Spectrum Equity Partners and Weston-Presidio (whose first fund just seven years earlier was in the $100-$200 million range) closed funds in 2000 well over $1 billion. (2) The average size of investments correspondingly grew much larger as well. Unheard of previously, start­up and early rounds of $20 million, $40 million, and even $80 million were plunked down in the dot-com and telecom feeding frenzy of the late 1990s. (3) The specialization pattern that began in the 1980s expanded to mainstream and megafunds.

The one significant trend that was reversed in the 1990s is especially good news for growth-minded companies. During the 1990s, start-up and early-stage funds experienced a major rebirth as opportunities in the Internet, software, information technology and telecommunications, and networking exploded. But the dot-com implosion left a lot of cash on the sideline. Many funds are looking to existing firms with track records and the potential for scale. Indeed, between 2000 and 2003 a majority of venture capital went to growth companies rather than start­up firms.12

Exhibit 5.4 U.S. Commitments (1969-2003)

110 r 105 "

100 -

95 -

90 -

85 -

80

75 _ 70 | S5

I 60 ffi 55 I 50 ■5 45 > 40

35

30

25

20

15

10 5

Exhibit 5.5 Total Venture Capital Under Management

402 48 2 M ,„,„ 31 34 30 1 303 31 6 3S 3 M ■

a a s s & s

Exhibit 5.6 New Heterogeneous Structure of the Venture Capital Market

Megafunds

Mainstream

Second Tier

Specialists and Niche Funds

Corporate Financial and Corporate Industrial

Estimated Number 106 - Predominantly
and Type (2000) private, independent

funds

76 - Predominantly 455 - Mostly SBICs;

private and indepen- some private

dent; some large insti- independent funds
tutional SBICs and
corporate funds

87 - Private, independent

114

Size of Funds

Under Management More than $500 million $250-$499 million

Less than $250 million $25-$50 million

$50-$ 100 million

Later expansion. Later stages; few LBOs, some start-ups; start-ups; mezzanine specialized areas

Typical Investment Series B, C, . .

$5-$25 million +

Stage of Investment Later expansion, LBOs, start-ups

Series A, B, C, $I-$I0 million

Series A, B: $500,000-$5 million

Series A, B: $500,000-$2 million

Seed and start-up; technology or market focus

Series A, B, C, $l-$25 million

Later

Strategic Focus

Technology; national and international markets; capital gains; broad focus

Technology and Eclectic - more High-technology
manufacturing; regional than national; national and inter­
national and regional capital gains, current national links; "feeder
markets; capital gains; income; service funds," capital gains
more specialized focus business

Windows on tech­nology, direct invest­ment in new markets and suppliers; diversi­fication; strategic partners; capital gains

Exhibit 5.6 New Heterogeneous Structure of the Venture Capital Market (continued)

				Corporate	O
			Specialists	Financial and	H
			and Niche	Corporate	O
Megafunds	Mainstream	Second Tier	Funds	Industrial	£

Predominantly equity

Balance of Equity and Debt

Principal Sources of Capital

Predominantly equity; convertible preferred

Mature national and international institu­tions; own funds; insurance company and pension funds; institutions and

Mature national and international institu­tions; own funds; insur­ance company and pension funds; institu­tions and wealthy indi-

viduals; foreign corpora- wealthy individuals;
tion and pension funds; foreign corporation
universities and pension funds;

universities

Predominantly debt (about 91 SBICs principally equity)

Wealthy individuals; some smaller institutions

Predominantly equity Mixed

Internal funds

Institutions and foreign companies; wealthy individuals

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