The Venture Capital Industry Overview Finance Essay
Venture capitalists do this by providing the funding and guidance — and by assuming the risks — necessary for building high-growth companies capable of bringing these innovations to the marketplace.
Many venture capitalists come to the industry after successful careers as scientists, engineers, doctors or entrepreneurs. Working through tight-knit firms, they raise money from pension funds, endowments, foundations and high-net-worth individuals to form a venture fund. This fund is then invested in the most promising start-up companies (which become part of the VC’s “portfolio”), typically over the course of 10 years.
VCs focus exclusively on companies developing significant innovations — be it a new piece of software, a life-saving cancer drug, or a new model for consumer sales. Unless the company is poised for significant growth, a VC won’t invest. Making investments at the earliest stages of a company’s development — often before a product or service is more than just an idea — involves significant entrepreneurial risk, which severely limits capital sources for such companies. Yet, venture capitalists assume this risk alongside the company founders by providing capital in exchange for an equity stake in the company.
During this investment stage, venture capitalists provide more than just money to the company. Typically, VCs take seats on the boards of directors and participate actively in company operations and management personnel. This commitment often includes providing strategic counsel regarding development and production, making connections to aid sales and marketing efforts, and assisting in hiring key management.
As part of this process, the venture capitalist also guides the company through multiple rounds of financing. At each point, the company must meet certain milestones to receive fresh funds for continued growth. If the company fails to meet these goals, the VCs’ responsibility to their investors may require them to walk away.
The VC’s goal is to grow the company to a point where it can go public or be acquired by a larger corporation (called an “exit”) at a price that far exceeds the amount of capital invested. Approximately one-third of portfolio companies fail, so those that do succeed must do so in a big way. Typically, when a venture-backed company exits the portfolio, the VC distributes the profits to the fund’s investors and eventually leaves the portfolio company’s board of directors. Once all the investments of a particular fund have been exited and the proceeds have been distributed, the fund ends. In many cases, however, the institutional investors reinvest these earnings in a new crop of funds and the process begins anew.
These elements — the patience, the hands-on guidance, the willingness to take on risk and fail — make venture capital unique as an asset class and enable it to drive U.S. economic growth faster and generate more jobs than other asset classes. Historically it has helped set the US economy apart from our international competitors.
Funding Innovation. Throughout its history, venture capital investment has built entire industry sectors by funding ground breaking innovations. From biotechnology to information technology to clean technology, thousands of start-ups have been brought to life, improving the way we live and work each day. Below are just a few examples of well-known companies who were originally venture-backed followed by a summary of the VC industry sectors created.
VC Geographical Differences: Venture capital, as an industry, has originated in the United States, and American firms have traditionally been the largest participants in venture deals, and the bulk of venture capital has been deployed in American companies. However, increasingly, non-US venture investment is growing, and the number and size of non-US venture capitalists have been expanding.
Venture capital has been used as a tool for economic development in a variety of developing regions. In many of these regions, with less developed financial sectors, venture capital plays a role in facilitating access to finance for small and medium enterprises (SMEs), which in most cases would not qualify for receiving bank loans.
In the year of 2008, while VC funding was still majorly dominated by U.S. money ($28.8 billion invested in over 2550 deals in 2008), compared to international fund investments ($13.4 billion invested elsewhere), there has been an average 5% growth in the venture capital deals outside the USA, mainly in China and Europe. Geographical differences can be significant. For instance, in the U.K., 4% of British investment goes to venture capital, compared to about 33% in the U.S.
Venture capitalists invested some $29.1 billion in 3,752 deals in the U.S. through the fourth quarter of 2011, according to a report by the National Venture Capital Association. The same numbers for all of 2010 were $23.4 billion in 3,496 deals. A National Venture Capital Association survey found that a majority (69%) of venture capitalists predicted that venture investments in the U.S. would have leveled between $20–29 billion in 2007.[
As of 2010, Israel led the world in venture capital invested per capita. Israel attracted $170 per person compared to $75 in the USA. About two thirds of the funds invested were from foreign sources, and the rest domestic.
Canadian technology companies have attracted interest from the global venture capital community as a result, in part, of generous tax incentive through the Scientific Research and Experimental Development (SR&ED) investment tax credit program. The basic incentive available to any Canadian corporation performing R&D is a refundable tax credit that is equal to 20% of "qualifying" R&D expenditures (labor, material, R&D contracts, and R&D equipment). An enhanced 35% refundable tax credit of available to certain (i.e. small) Canadian-controlled private corporations (CCPCs). Because the CCPC rules require a minimum of 50% Canadian ownership in the company performing R&D, foreign investors who would like to benefit from the larger 35% tax credit must accept minority position in the company, which might not be desirable. The SR&ED program does not restrict the export of any technology or intellectual property that may have been developed with the benefit of SR&ED tax incentives.
Canada also has a fairly unique form of venture capital generation in its Labor Sponsored Venture Capital Corporations (LSVCC). These funds, also known as Retail Venture Capital or Labor Sponsored Investment Funds (LSIF), are generally sponsored by labor unions and offer tax breaks from government to encourage retail investors to purchase the funds. Generally, these Retail Venture Capital funds only invest in companies where the majority of employees are in Canada. However, innovative structures have been developed to permit LSVCCs to direct in Canadian subsidiaries of corporations incorporated in jurisdictions outside of Canada.
Europe has a large and growing number of active venture firms. Capital raised in the region in 2005, including buy-out funds, exceeded €60 billion, of which €12.6 billion was specifically allocated to venture investment. The European Venture Capital Association includes a list of active firms and other statistics. In 2006, the top three countries receiving the most venture capital investments were the United Kingdom (515 minority stakes sold for €1.78 billion), France (195 deals worth €875 million), and Germany (207 deals worth €428 million) according to data gathered by Library House.
European venture capital investment in the second quarter of 2007 rose 5% to €1.14 billion from the first quarter. However, due to bigger sized deals in early stage investments, the number of deals was down 20% to 213. The second quarter venture capital investment results were significant in terms of early-round investment, where as much as €600 million (about 42.8% of the total capital) were invested in 126 early round deals (which comprised more than half of the total number of deals). Private equity in Italy was 4.2 billion Euros in 2007.
India is fast catching up with the West in the field of venture capital and a number of venture capital funds have a presence in the country (IVCA). In 2006, the total amount of private equity and venture capital in India reached US$7.5 billion across 299 deals. In the Indian context, venture capital consists of investing in equity, quasi equity and/or conditional loan in order to promote unlisted, high risk or high tech firms driven by technically or professionally qualified entrepreneurs. It is also defined as ‘providing seed’,’ start up and first stage financing’ . It is also seen as financing companies that have demonstrated extraordinary business potential. Venture capital refers to capital investment; equity and debt; both of which carry indubitable risk. The risk anticipated is very high. The venture capital industry follows the concept of “high risk, high return” Innovative entrepreneurship, knowledge based ideas and human capital intensive enterprises have taken the front seat as venture capitalists invest in risky finance to encourage innovation.
China is also starting to develop a venture capital industry (CVCA).
Vietnam is experiencing its first foreign venture capitals, including IDG Venture Vietnam ($100 million) and DFJ Vinacapital ($35 million).
The Middle East and North Africa (MENA) venture capital industry is an early stage of development but growing. The MENA Private Equity Association Guide to Venture Capital for entrepreneurs lists VC firms in the region, and other resources available in the MENA VC ecosystem.
The Southern African venture capital industry is an early stage of development, mostly centered in South Africa. Funds are difficult to come by and very few firms have managed to get funding despite demonstrating tremendous growth potential. Generally the climate for venture capital industry is poor.
Frequently Asked Questions About Venture Capital:
What kind of investors are venture capitalists? Venture capitalists are professional investors who specialize in funding and building young, innovative enterprises. Venture capitalists are long-term investors who take a hands-on approach with all of their investments and actively work with entrepreneurial management teams in order to build great companies.
Where do venture capitalists get their money? Most venture capital firms raise their "funds' from institutional investors, such as pension funds, insurance companies, endowments, foundations, family offices, and high net worth individuals. The investors who invest in venture capital funds are referred to as "limited partners." Venture capitalists, who manage the fund, are referred to as "general partners." The general partners have a fiduciary responsibility to their limited partners.
How many venture capital firms are there in the U.S.? In 2010, there were 462 active US venture capital firms, defined as investing at least $5 million in companies. This compares with 1,022 such firms at the height of the tech bubble in 2000. If you define the universe of US venture capital firms as those raising money in any of the last 8 years, the 2010 count was 791. These firms managed $176.7 billion in committed capital.
What's the average size of a venture capital fund? In 2010, the average venture fund size was $149 million.
How many companies receive venture capital financing each year? In 2010, venture capitalists invested approximately $22 billion into nearly 2,749 companies. Of these, 1,001 companies received funding for the first time.
What types of companies and industries do venture capitalists invest in? Venture capitalists invest mostly in young, private companies that have great potential for innovation and growth. Venture capitalists have been instrumental in developing sectors such as the computer, biotechnology and the communications industries. Today, the majority of venture capital is invested in high technology companies including software, biotechnology, medical devices, media and entertainment, wireless communications, Internet, and networking. In the last five years, the venture industry has also committed itself to investing in the clean technology sectors which include renewable energy, environmental and sustainability technologies and power management. However, venture capitalists also invest in innovative companies within more traditional industries such as consumer products, manufacturing, financial services, and healthcare services and business products and services.
What impact does venture capital have on the economy? Venture capital activity has a significant impact on the U.S and global economies. Venture capital is a catalyst for job creation, innovation, technology advancement, international competitiveness and increased tax revenues. According to the 2011 Venture Impact study, produced by IHS Global Insight, originally venture-backed companies accounted for 11.87 million jobs and over $3.1 trillion in revenue in the United States (based on 2010 data). Those totals compare to 21% of GDP and 11% of private sector employment.
How are venture capitalists different from other investors? Venture capitalists are long-term investors who take a very active role in their portfolio companies. When a venture capitalist makes an investment he/she does not expect a return on that investment for 7-10 years, on average. The initial investment is just the beginning of a long relationship between the venture capitalist and entrepreneur. Venture capitalists provide great value by providing capital and management expertise. Venture capitalists often are invaluable in building strong management teams, managing rapid growth and facilitating strategic partnerships.
How do venture capitalists realize a return on their investment? The companies that venture capitalists invest in are private enterprises. Typically, the venture capitalist realizes a return on their investment when the company goes public (IPO) or is merged or purchased by another company (M&A).
What percentage of venture-backed companies succeed? Venture capitalists invest in high-risk enterprises. However, venture capitalists manage that risk through portfolio risk management. It is estimated that 40 percent of venture backed companies fail; 40 percent return moderate amounts of capital; and only 20 percent or less produce high returns. It is the small percentage of high return deals that are most responsible for the venture capital industry consistently performing above the public markets.
How does angel investing differ from venture capital? Venture capital firms are professional investors who dedicate 100% of their time to investing and building innovative companies on behalf of third party investors or their limited partners. The angel investment community is a more informal network of investors who invest in companies for their own interests. Typically, angel investors invest less than $1 million in any particular company, whereas venture capitalists usually invest more than $1 million per company.
What's the difference between venture capital and private equity? Venture capital is a subset of the larger private equity asset class. The private equity asset class includes venture capital, buyouts, and mezzanine investment activity. Venture capital focuses on investing in private, young, fast growing companies. Buyout and mezzanine investing focuses on investing in more mature companies. Venture capitalists also invest cash for equity. Unlike buyout professionals, venture capitalists do not use leverage in their transactions.
What impact does corporate venture investing have on the venture industry? Many corporations have been active venture capital investors for many years. Corporate venture capitalists often co-invest with traditional venture capitalists. Besides being savvy investors, many corporate venture capitalists provide their portfolio companies access to corporate distribution channels and potentially important strategic partners.
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