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.
VC’s Provide Risk Capital for High-Growth Businesses
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:
- Could not be financed with traditional bank financing;
- Threaten established products and services in a corporation or industry; and
- Typically require five to eight years (or longer!) to reach maturity.
Venture capital is quite unique as an institutional investor asset class. Venture capitalists create partnerships with pension funds, endowments, foundations, and others to make high-risk, long-term equity investments into innovative young companies. This capital is used to conduct research, expand workforces, build out new facilities, and generally focus on growth activities that create long-term value. Venture capital has the longest asset holding periods of any investment class and often invest in companies with little to no liquidity. In fact, the standard VC partnership agreement lasts for ten years with extensions that in practice mean the partnerships generally run even longer.
Venture Investors Partner with Entrepreneurs
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 capitalist’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 capitalist who has had an ultra-successful investment will tell you that the companies capable of breaking through were able to evolve the original business plan concept due to careful input from an experienced hand.
A VC Firm: Common Structure – Unique Results
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 $100 million. 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, the venture firm works with the founding entrepreneur to grow the company.
The payoff comes after the company is acquired or goes public. Although the investor has 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.
The Impact of VC-backed Companies
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, analyzed the impact venture-backed companies, as a subset of all U.S. public companies founded after 1974, have had on the economy. The study found that of the 1,339 U.S. companies that went public between 1974 and 2015, 556 (or 42%) are venture-backed. These 556 companies represent 63% of the market capitalization and 85% of total research and development of those 1,339 companies.
At the end of 2018, venture-backed companies accounted for five of the six largest publicly traded companies by market capitalization: Microsoft ($780B), Apple ($746B), Amazon ($737B), Alphabet ($727B), and Facebook ($374B).
