Venture capital has enabled the United States to support its entrepreneurial talent by turning ideas and basic research into products and services that have transformed the world. Venture capital funds build companies from the simplest form—perhaps just the entrepreneur and an idea expressed as a business plan—to freestanding, mature organizations.
Venture capital firms are professional, institutional managers of risk capital that enable and support the most innovative and promising companies. Venture capital supports new ideas that 1) could not be financed with traditional bank financing; 2) threaten established products and services in a corporation or industry; and 3) typically require five to eight years (or longer!) to reach maturity.
Venture capital is quite unique as an institutional investor asset class. Venture capital funds make equity investments in a company whose stock is essentially illiquid and worthless until a company matures five to eight years down the road. Follow-on investment provides additional funding as the company grows. These “rounds,” typically occurring every year or two, are also based on equity in the company, with the shares allocated among the investors and management team based on an agreed “valuation.” However, unless a company is acquired or goes public, there is little actual value. Venture capital is a long-term investment.
The U.S. venture industry provides the capital to create some of the most innovative and successful companies. However, venture capital is more than money. A venture capital professional’s most precious asset is time. According to a 2016 study, How to Venture Capitalists Make Decisions?[1], for every company in which a venture firm eventually invests, the firm considers roughly 100 potential opportunities. The same study, which included results from a survey of 889 venture capital professionals at 681 firms, showed that the median venture firm closes about four deals per year. Team, business model, product, market, valuation, fit, ability to add value, and industry are all important factors venture investors consider when evaluating investments into startups. Venture capital investors are seeking entrepreneurs who are addressing global markets, have superb scalability, demonstrate success within a reasonable timeframe, and are truly innovative.
A venture capital investor’s competitive advantage is the expertise and guidance they provide to the entrepreneurs in their portfolio. Once the investment into a company has been made, venture capital partners actively engage with a company, providing strategic and operational guidance, connecting entrepreneurs with investors and customers, taking a board seat at the company, and hiring employees. With a startup, daily interaction with the management team is common. This active engagement with a fledgling startup is critical to the company’s success and often limits the number of startups into which any single fund can invest. Many one- and two-person companies have received funding, but no one- or two-person company has ever gone public! Along the way, the company must recruit talent and scale up. Any venture capital investor who has had a “home-run” investment will tell you that the companies capable of breaking through the gravity were able to evolve the original business plan concept due to careful input from an experienced hand.
While the legal and economic structures used to create a venture capital fund are similar to those used by other alternative investment asset classes, venture capital itself is unique. Typically, a venture capital firm will create a Limited Partnership with the investors as LPs and the firm itself as the General Partner. Examples of LPs include public pension funds, corporate pension funds, insurance companies, family offices, endowments, and foundations. Each “fund,” or portfolio, is a separate partnership.
A new fund is established when the venture capital firm obtains necessary commitments from its investors, say $80 million (i.e., the median size of a U.S. venture fund closed in 2019). The money is taken from Limited Partners as the investments are made through what are referred to as “capital calls.” Typically, an initial funding of a company will cause the venture fund to reserve three or four times that first investment for follow-on financing. Over the next three to eight years, partners from the venture firm works with the founding entrepreneur to grow the company. The potential payoff comes only after the company is acquired or goes public. Although venture investors have high hopes for any company getting funded, the 2016 study How Do Venture Capitalists Make Decisions? found that, on average, 15% of a venture firm’s portfolio exits are through IPOs while about half are through an M&A.
Venture capital is rare among asset classes in that success is truly shared. It is not driven by quick returns, financial engineering, debt, or transaction fees. Economic success occurs when the stock price increases above the purchase price. When a company is successful and has a strong public stock offering, or is acquired, the stock price of the company reflects its success. The entrepreneur benefits from appreciated stock and stock options. The rank and file employees throughout the organization historically also do well with their stock options. The venture capital fund and its LP investors split the capital gains per a pre-agreed formula. Many college endowments, pension funds, charities, individuals, and corporations have benefited far beyond the risk-adjusted returns of the public markets.
At the same time, the risk capital that fuels startups can bring benefits to local economies in the form of company growth, competitiveness, and job creation. In fact, recent studies have found that high-growth startups account for as many as 50% of gross jobs created, and an average of 2.9 million net jobs created annually between 1980 and 2010
Venture capital is rare among asset classes in that success is truly shared. It is not driven by quick returns, financial engineering, debt, or transaction fees. Economic success occurs when the stock price increases above the purchase price. When a company is successful and has a strong public stock offering, or is acquired, the stock price of the company reflects its success. The entrepreneur benefits from appreciated stock and stock options. The rank and file employees throughout the organization historically also do well with their stock options. The venture capital fund and its LP investors split the capital gains per a pre-agreed formula. Many college endowments, pension funds, charities, individuals, and corporations have benefited far beyond the risk-adjusted returns of the public markets.
At the same time, the risk capital that fuels startups can bring benefits to local economies in the form of company growth, competitiveness, and job creation. In fact, recent studies have found that high-growth startups account for as many as 50% of gross jobs created, and an average of 2.9 million net jobs created annually between 1980 and 2010
While venture investing has generated billions of dollars for investors and their institutions and created millions of jobs over the years, the economic impact of venture-backed companies has been even more far-reaching. Many venture-backed companies have scaled, gone public, and become household names, and at the same time have generated high-skilled jobs and trillions of dollars of benefit for the U.S. economy.
A 2015 study, The Economic Impact of Venture Capital: Evidence from Public Companies[3], analyzed the impact venture-backed companies, as a subset of all U.S. public companies founded between 1974 and 2015, have had on the economy. The study found that of the 1,339 U.S. companies that went public in that period, 556 (or 42%) are venture-backed. These 556 companies represent 63% of the market capitalization and 85% of total research and development.
At the end of 2019, venture-backed companies accounted for the five largest publicly traded companies by market capitalization in the U.S.: Apple ($1.29 trillion), Microsoft ($1.20 trillion), Alphabet ($920.3 billion), Amazon ($920.2 billion), and Facebook ($585 billion).[4]
Furthermore, recent research released by Silicon Valley Bank found that 42% of FDA-approved U.S. drugs between 2009 and 2018 originated with venture capital funding
Much of venture capital’s success has come from the vibrant entrepreneurial spirit in the U.S., financial recognition of success, access to good science, a pipeline of talent, and fair and open capital markets. It is dependent upon investment in scientific research, motivated entrepreneurs, protection of intellectual property, a skilled workforce, and public policies that encourage new company formation. The nascent deployment of venture capital in some countries is gated by a country’s or region’s cultural fit, tolerance for failure, services infrastructure that supports developing companies, intellectual property protection, efficient capital markets, and the willingness of big business to purchase from small companies.
Venture capital investing is now global. While the U.S. historically has held a stronghold on global venture capital activity, the rest of the world has been catching up. In the 1990s, U.S.-based startups attracted more than 90% of annual global venture capital dollars invested. Today, U.S.-based startups account for about half of global venture capital dollars invested. It’s important to note that global investment has grown over that time, i.e., the U.S. decline in global market share is on relative terms, not by absolute dollars. However, with global competition increasing for innovation and talent, empowering high-growth startups and ensuring the U.S. is the most attractive place to start a company are critical to the continued success of our country’s entrepreneurial ecosystem.