VENTURE CAPITAL



The term "venture capital" (VC) usually refers to third-party private equity capital for new and emerging enterprises. Companies that specialize in providing this funding are known as venture capital firms or simply venture capitalists. In practice, venture capital firms often provide the entrepreneur with more than just money; since they usually become part owners in the firm, they frequently take an active role in shaping the company's business strategy and its management —including possibly installing one or more experienced executives from the outside.

While the venture capital firm may be affiliated with banks or other lending institutions, most are independent and privately managed. Their efforts are focused; business activity is limited to working with start-ups or young organizations. Venture capital organizations provide their clients with capital through direct equity investments, loans, or other financial arrangements. Due to the highly speculative nature of their investments, venture capitalists take big risks by working with new ventures. Indeed, the majority of companies they finance don't pan out. In exchange for the high level of risk, venture capitalists expect a high return on their investments from the few that do turn into successful enterprises.

FORMATION OF VENTURE CAPITAL
FIRMS

All businesses need some financial resources to begin activity. The exchange between someone with a good idea (an entrepreneur) and someone with the resources to help make a business out of the idea (a banker, a rich uncle, or a venture capitalist) is as old as business itself. However, venture capital as a distinct form of business financing arose only recently. John Wilson, in his book The New Ventures, Inside the High Stakes World of Venture Capital, marks 1946 as the year the venture capital industry originated in the United States. J.H. Whitney brought together partners from the East Coast for the first venture capital fund, working with an initial capitalization of approximately $10 million. The structure of the first fund—a partnership between those contributing to the initial capitalization—was the model for a majority of venture capital organizations that followed as the industry grew.

One of the first venture capital funds was created by city leaders in Boston. The American Research and Development Corporation was headed by General George Doriot, one of the early leaders in the industry. The successful investments made by this group helped to legitimize the new form of financing. Burill and Norback, in their book The Arthur Young Guide to Raising Venture Capital argue that Doriot's leadership set the course for future venture capital organizations. "Doriot… is famous for instituting the ethos of the venture capital industry—the venture capitalist as one who guides and manages a growing company through times thick and thin." ADR, and Doriot, gained attention because of the success of one of their first clients, Digital Equipment Corp. (DEC). The American Research and Development Corporation's initial investment of $67,000 grew into more than $600 million.

The passage of the Small Business Investment Act of 1958 by the federal government was an important incentive for would-be venture capital organizations. The act provided venture capital firms organized as Small Business Investment Companies (SBICs) and Minority Enterprise Small Business Investment Companies (MESBICs) with an opportunity to increase the amount of funds available to entrepreneurs. The privately managed SBICs and MESBICs had access to federal money through the Small Business Administration which could then be leveraged four dollars to one against privately raised funds. The SBICs and MESBICs, in turn, made the financial resources available to new ventures and entrepreneurs in their communities.

In recent decades, the venture capital industry has become big business. According to a widely cited annual estimate published by VentureOne Corporation, venture capital firms in 1998 disbursed approximately $12.5 billion in funds to approximately 1,800 new or continuing ventures. This level of funding was nearly double that just three years earlier. Part of the trend has been to invest more money in the typical new venture: the average size of investment in 1998 was approximately $6.8 million, compared with $5.4 million per deal as of 1995. These figures don't include so-called angel investors and venture capital provided by sources outside the mainstream venture capital industry, such as when large corporations provide equity funding to small strategic business partners.

As more capital has entered the VC arena, the focus of venture capital firms has also gradually shifted. Whereas the first venture capitalists provided money to organizations for very basic initial start-up activities, the industry increasingly looks for firms that are somewhat further along in their development. As a result, there is a tendency for venture capital organizations to shy away from early stage and startup financing. Rather than provide the entrepreneur or new venture with money early on in the growth of the business (in the first year of business, for instance), venture capital firms increasingly provide funds for products and services with proven markets and a higher chance of success in the marketplace.

INSTITUTIONALIZATION

What may have started out as a relatively loose partnership of individuals with money to invest has become a set of organizations with formalized structures and business activities. Venture capital firms, or financial firms that offer venture funds along with other financing options, have become accepted parts of the business world, finding their own niche as providers of capital for higher risk situations.

As the industry matures, two types of organizations predominate those disbursing venture capital. The structure of the venture organization usually dictates the means through which the organization makes a profit. Leveraged firms borrow money from other financial institutions, the government or private sources and, in turn, lend the funds to entrepreneurs and new ventures at a higher rate of interest. Leveraged firms make money by charging their clients a higher interest rate than they pay for the use of the funds. Because leveraged firms rely on interest income, they make most of the disbursements in the form of loans to new ventures. This practice is less common among firms that are dedicated to providing venture capital.

Equity firms sell stock in the venture capital organization to individual or institutional investors, in effect pooling investors' money, and then use the proceeds to purchase equity in new ventures. Equity venture capital firms build portfolios of investments in companies. This kind of venture capital company tries to resell the stock of its portfolio businesses at a later date for a profit. Whereas a leveraged firm can expect a relatively steady stream of interest income, an equity firm may not experience a return on their investment for years. The return usually comes as a result of the sale of their equity in the new venture. Venture capital organizations can either sell their equity back to the company itself or on the public stock exchanges (like the New York Stock Exchange) in an initial public offering (IPO).

There are a variety of ownership structures for venture capital firms. A few firms are publicly traded on the stock exchanges. Because of the nature of the ownership, these firms tend to be larger than most venture capital organizations. However, the overwhelming majority of firms are private companies. The firms may have been formed by individuals, families, or small groups of investors. Some are also limited partnerships formed by insurance companies or pension funds. These organizations generally form the venture capital organizations to achieve a greater rate of return than most of their other investments. Other firms are organized as bank subsidiaries as a way for the banks to own equity in small businesses. These organizations are independent of other bank activities. Some firms have been set up by corporations, although these are relatively rare. In other cases, corporations looking to gain high returns on their funds invest in existing venture capital limited partnerships where risk can be shared and liabilities are limited.

FORMS OF VENTURE CAPITAL
FINANCING

Venture capital firms invest at different stages in the development of the enterprise, often according to their own particular investment strategy. The managers of a venture capital firm may prefer to invest in brand new companies or their strategy may dictate investment in businesses that are much more developed. Because the business is unproven, early investments are inherently more risky and the firm can demand a higher return. Later investments are more stable and bring a more modest return. Most venture capital firms try to diversify their holdings by investing in a variety of enterprises at various stages of development.

"Seed capital" is given to individuals or groups in the idea stage, the point at which there is a good idea for a business but no formal organization. At this stage, the entrepreneur is likely to use the money provided by a venture capital organization to conduct further market research, assemble a management team, or develop a prototype.

More often than not, those who look for seed capital are turned down by venture firms and must rely on their own resources to find the needed capital. However, after they have developed a prototype and proved their idea will be viable, new enterprises may approach a venture capital in order to gather funds needed to begin operations. In such cases, venture capital organizations provide "start-up" or "first-round" financing to give the growing business sufficient capital to meet the demands of defining and developing customer base and creating solid relationships with suppliers. First-round financing usually comes in the form of an equity investment. Venture firms will expect a higher rate of return for first-round investments.

As a new venture prospers, it may require additional financing to meet the capital needs inherent in expansion. Venture firms can provide second-round or "expansion-round" financing to their clients whose markets or sales are growing at such a rate that potential for profit looks good. At this point, the venture is usually heading towards success. Assuming the venture's early sales or sales commitments and general market prospects still appear strong, those seeking expansion financing are in a better bargaining position than those seeking first-round or seed money.

If the expansion stage is successful, the new venture may begin a period of fast growth. At this point, the company may be making money, but not enough to finance the rapid expansion. Additional "growth stage" or third-round capital may be solicited from venture capital firms. In other cases, the new venture may consider "going public," or offering equity on the public markets as a means of gaining a cash infusion.

In addition to financing different stages of growth, venture capital firms can be of service to entrepreneurs in other, related situations. Some venture firms will assist management in a merger, acquisition, or other form of buyout, where the stock of a company is purchased by a management team or a group of other entrepreneurs with the help and financial support of the venture capital firm's managers. In such a case, the money used to purchase the business is loaned to the buyout team by the venture capital firm. Another area of activity for some venture capital firms is "turnaround financing" for businesses that have suffered serious setbacks or are nearing bankruptcy. Funds provided by a venture capital firm are used to finance recovery efforts or launch new programs aimed at turning the business around. Although few firms undertake the risk inherent in financing a turnaround situation, most are willing to consider them as part of their business strategy.

THE SCREENING PROCESS

Competition for venture capitalists' limited funds is extremely intense, and often less than I percent of companies that solicit funds actually receive any. Generally only firms with significant growth potential are considered, and thus venture capital is not an option for small, individual-based businesses with less ambitious plans. A typical recipient of venture capital will expect sales in the tens of millions of dollars within the first couple years of their product or service reaching the market, and much larger long-term potential.

Other factors that influence the investment decision include:

The screening process usually begins formally when the business seeking capital submits a business plan to the venture capital firm, although in practice often there is some form of interpersonal networking leading up to the submission, such as by word of mouth among mutual friends or business associates. Often, start-up firms enlist the support of experienced and well-placed attorneys or accountants who have worked with venture capitalists in the past. Indeed, there are law firms that specialize in this sort of practice. At the very least, usually the head of the start-up firm makes personal contact with a decision maker at the venture capital company via a phone call around the time the plan is submitted.

Venture capitalists scrutinize the business plan and the company submitting it thoroughly before proceeding any further. The venture capital firm must be confident that the claims made by the entrepreneur are realistic and attainable in general, and that the particular company and management team at hand is capable of pulling it off. In both the plan and any subsequent meetings, the venture capitalist attempts to size up the management's clarity of purpose, ability to cope with adversity, and market focus, among other things.

The venture capital firm must also have confidence the investment will pay out according to the plans offered by the entrepreneur. Before a venture capital firm makes an investment, it thoroughly investigates the client and the client's business in a process called due diligence. Due diligence simply means extensive research into the industry, the entrepreneur's background and experience, and the reliability of the financial projections supplied by the client. In addition, the due diligence process may include a visit to the client's place of business or questions about the client's personal and professional history. By conducting research into the client, the venture capital firm tries to maximize its understanding of the opportunity and its potential risks and rewards. By accumulating information, the venture capital firm better prepares itself to make the best possible decision about the investment.

After the venture capital firm is confident in the abilities and claims of the entrepreneur, it must be certain that it understands the market in which the new venture will operate. The experience and specialties of the firm's management will dictate whether or not the firm will narrow the focus of their business. Some venture capital firms specialize in certain industries or specific technologies. There are firms that only invest in, for instance, computer network technology businesses. Other firms only work with businesses in the biotechnology field. Consequently, VC firms that have such specialties turn away those businesses that don't fit into their area of expertise.

In recent years in there has been a pronounced emphasis on emerging technology—especially computer-related—by venture capitalists. In 1998, for example, almost two-thirds of all venture capital, or $7.8 billion, was devoted to information technology (IT) ventures, according to a VentureOne report. In particular, much of this money was funneled into IT communications applications, including Internet-based technologies. Health-related ventures (often also technological in nature) were a distant second, at $2.7 billion, or 21 percent of all venture capital.

FURTHER READING:

Burrill, G. Steven, and Craig T. Norback. The Arthur Young Guide to Raising Venture Capital. Billings, MT: Liberty House, 1988.

Gibson, Paul. "The Art of Getting Funded." Electronic Business, March 1999.

Gladstone, David J. Venture Capital Handbook. Rev. ed. Englewood Cliffs, NJ: Prentice Hall, 1988.

Littman, Jonathan. "The New Face of Venture Capital." Electronic Business, March 1998.

VentureOne Corporation. "1998 Investment Highlights." Industry Data. San Francisco, 1999. Available from www.ventureone.com .



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