Why Venture Capital is Key to Our Economic Recovery
As we continue to reel from the unthinkable (as in "what were we thinking?") excesses of gorging on huge amounts of unsecured debt throughout our economy, we need to think clearly about the financial tools that will allow us to recover our footing, grow our economy and create well-paid sustainable jobs. While debt financing will undoubtedly make a comeback, albeit in a more prudent mode, real equity will have to be invested if we want to break the cycle that got us here in the first place.
One of the proven methods of deploying equity to finance innovation and the creation of new enterprises is venture capital.
Venture capital funds invest in new or unproven enterprises. These funds come in the form of equity that is invested in new companies. While this equity usually commands a preferred return to compensate for the risk of backing unproven companies, venture capital funds do not earn any return unless there is a financial "exit" for the organization as a whole in which all shareholders benefit. Until that exit (which can take many years), the venture capitalists (VCs) stand shoulder-to-shoulder with the founders and management of the companies they back, for better or worse. If the company fails, the VCs typically lose all. If the company is successful, the VCs make a return -- but so do the other shareholders.
Venture capitalists bring managerial and technical expertise to the companies they invest in. They bring experience and open their Rolodex. They find multiple ways to be helpful, to promote the companies' varied agendas. But VCs don't manage the companies directly. They are minority shareholders who act as advisors to the brilliant innovators, the individuals whose ideas will create whole new markets or transform existing ones.
The U.S. has the most developed and sophisticated venture capital industry in the world. The industry has helped build significant companies in technology (Compaq, Yahoo, Google), biotech (Genentech), health care, medical devices, financial services (eTrade), retail (Home Depot), renewable energy and pretty much every segment of the economy.
Despite these successes, venture capital represents a tiny and largely misunderstood part of the financial services sector. Venture capital is also known as "risk capital" since only a relatively small number of new companies will be successful -- and a smaller number yet will be the next Google. However, VC funds are organized in pools of capital -- capital which is invested in a portfolio of companies -- and the returns are derived from the combined results of that pool. Over the years, venture capitalists have delivered positive returns as an asset class. Venture capital investments also take a few years to mature and, as a result, have largely been avoided by investors looking for quick returns in a booming stock market (when that existed).
Venture capital is also often equated with private equity, two business models which couldn't be more different. Private equity (PE) used to be known as leverage buy-outs or "LBOs" (someone figured out early that "leverage" would become a detested term). PE firms generally acquire controlling interests in public companies by investing a combination of a small amount of equity and a large amount of debt (slapped onto the acquiring company's balance sheet). These firms then manage these companies with a tight fist, extracting as many fees and dividends as they can get away with. In a euphoric market, returns to the PE funds and its limited partners can be large and quick. In today's market, that business model is dead while the venture capital model lives on.
Big companies have been shedding jobs for years. In the current economy, big companies are jettisoning employees at a furious pace. These companies are not going to be hiring any time soon. When the economy picks up, they'll find ways to stay lean. The only source of new jobs (apart from the government, and that's another story) will come from start-ups and existing small businesses. We need a lot of new businesses to pick up the slack. We need more venture capital.
But at a time when we should be expanding VC funding, the opposite is likely to happen. Pension funds and endowments are among the largest sources of new capital for VCs. Their portfolios of public stocks have declined so much that their usual allotment for venture funds is over the authorized levels. And a majority of these funds lump venture capital and private equity into the same category -- one which, given the broken model of private equity, is now viewed with a great deal of skepticism.
Most venture capitalists are experienced, responsible professionals with outstanding track records of successfully growing new companies that have benefited society through innovation and new jobs. Depriving VC funds of sources of capital at a time when they're needed the most will only slow our economic recovery further. Pension funds, endowments and other venture limited partners should continue to set aside pools of capital with long-term appreciation, and view venture capital as a single asset class -- one that is key to our economic recovery.
Full Disclosure: I am a Managing Partner at venture capital fund Softbank Capital, an investor in The Huffington Post and I am on the Board of the company.
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Our economy is falling apart right now because of financial industry expectations and manipulations. VC's fall into that category perfectly. They expect huge returns on extremely short-term contracts, often something like 200% after 2 years. The incentive behind such a contract is to take the money and run, without any focus on building a sustainable business enterprise.
Fail a VC's contract expectations? They will pull the plug, and leave you high and dry. There is no altruism behind their motivations, only short-sighted greed.
chilizm?
Venture capitol brought you electricity, light bulbs, heating, air conditioning, automobiles, airplanes, refridgerators, washing machines, dryers, telelphones, televisions, the internet and on and on. Do you have another way to do this chilizm and if not what’s your point?
TS
A capitol is a government building. And the technology of the Internet was created mostly through scholarly efforts and government funding -- VC only helped standardize it and make it more accessible to the public once it was already developed.
And yes, there are ways to create new technology without the ongoing, rapacious greed that comes with the traditional VC model. Investors don't tend to use other models because they don't have to.
Venture capitalists are not altruistic or white knights with open wallets for fledgling start ups nor should they be. They are risking their capital and for that risk a high return is expected and a strictly monitored time frame will be demanded.
As an FYI, the longest time frame I have seen for return of capital recently in a VC deal is 5 years. The idea is to get in and out quickly and turn your money. If a company does not meet bench marks in short order, the plug is often pulled.
High annual returns of 25% to 60% on investment could be expected. Controls will be injected and enforced with positions on your board of directors. Their consultants will be inserted with hiring and firing power. If you don't think the screws will be turned if things are not going according to plan, you still believe in Santa Claus.
In my humble opinion, since investors want your “skin in the game,” your first source of money should be your own dollars, next “family, friends, and fools,” then grants, followed by even SBA type loans, angel investors, and finally venture capitalists. Having spent time in both camps, angels would be preferred if you were looking for 1 or even $2 million. You could always opt for additional financing rounds if all went well. VCs have grown strict with funding and may be more receptive when you have product, multiple customers and cash flow.
I think venture capitol has been responsible for more failures than successes with new business enterprises. Easy money retards creativity and leads to concerns of getting to payback time rather than to how to grow a really profitable business over a long period of time. Venture capitol can fly some businesses but not most. I feel sorry for people who need others people money to make money. It is a losing game for the idea people. If you can, stay away from venture capitalists, because if you do sign on the dotted line you might as well get a 711 franchise and work the rest of your life for peanuts.
The government has supported start-up and late-stage companies for years via the SBIR and SBA administration, along with separate ARPA (Then DARPA, and back again), NIST (formerly NBS National Bureau of Standards). This support has been used to help some companies go public: then fail also. Unfortunately, the goverment contract monitors need to look busy to support their GS service career, and will cut the legs out from nongovernment funded entities. Don't even get me started about University professors running SBIR companies with their H1-B grad students "out of lab."
Most small businesses, the ones that actually generate most of the jobs (companies with under 25 employees), have a better chance of being hit by a falling meteorite than ever getting a nickel of equity money from wonderful venture capital system described here. Funding rates rarely exceed 1 in 200 for fully developed business plans from established entrepreneur teams and they are much lower for beginners. Most VCs these days won't touch a deal where the investment is less than $3-5 million.
Thank you Eric. You might want to post comments on http://www
Sincerely,
Ken Stremsky
VC funds can facilitate job creation and innovation when they invest in new companies and innovative ideas. Unfortunately most present day VC funds are extremely risk averse. No longer can an entrepreneur get the seed investment necessary from a VC firm to build a company. Most VC firms now require the companies they consider investing in to already have revenues, established management teams with track records and business models that the VC partners can understand. (Therefore, the 'Lemming Effect'). Where does that leave the entrepreneur starting the next generation of anything? That is not the best way to stimulate job growth and innovation.
It would probably be a good idea for the federal government to set up their own VC funds managed by successful entrepreneurs and visionaries. A certain percentage of each fund would be allocated to seed investments in new, viable ideas. Taxpayers would then become investors in American innovation and reap the benefits of these potentially profitable enterprises.
If current VC firms were to receive some of this federal government innovation investment money they should be required to invest in seed stage startups with those government funds.
I think VC are, like everyone else, self-scaling to the opportunities that present themselves. If banks won't lend money on expansion plans, the only route forward for businesses is VC. They charge more but have the millions.
But the party is over for banks making massive returns by approving bogus mortgages. When they DO start lending again, they will be competing with VC for the kinds of reduced-risk expansion or roll out plans you are talking about, and business will use banks and loans instead of giving up equity.
Then the VC are driven back into their proper field; high risk for high return, which the banks will again be prohibited from engaging in. The VC behavior you are talking about is an artifact of the current crisis in deregulation and complete failures of bank and corporate oversight under existing law. When that is corrected, hopefully businesses can use more textbook means of financing growth without giving up equity, and the only field left for VC will be the truly new ventures and new ideas.
The good news is that the rich did get richer in the last eight years, and still have to put that money somewhere. Now that Madoff is exposed and other routes to high returns (like hedge funds) are going to get tightened or close, I think VC will be flush with new investors within a few years. VC really do offer the highest returns, and big money has to go somewhere.
What we need is some very tight regulations on Wall Street and we need to get our banking industry to lend money again.
Hedge Funds and so called Derivatives have failed us miserably; we can no longer allow the banks to continue business like usual.
They also have to pay the cost of the mess they created, no bailout for them.
Banks are the country’s lending institution. They have to be forced to invest in the real economy, like start up businesses (preferred manufacturing), and small and medium sized company’s, the back bone of our economy.
President Obama is going in the right direction and he needs our strong support in order to brake with corporate America and the establishment.
So, get a peddelers license, build a push cart, find a good corner.
We are going to become a third world country.
The government could provide Venture Capital insurance and then drop back to provide reinsurance - until after a suitable time span, both functions were able to attract private insurance and reinsurance companies.
Some years ago during a previous venture drought I did a study for a Commerce Department Agency that suggested a path to making this happen. The Agency wanted to try it, but Congress never funded the experiment.
A good example of how wrong Republican John Boehner's comment on the stimulus package is wrong. He says we can't borrow and spend our way out of recession. In fact, how do most big new ventures get started, exactly? Somebody risks losing a lot of money to make something new happen, and although only a few succeed, the ones that do make up for all the losses.
For us it is time to invest in infrastructure. Look at the economic impact of the Interstate Highway program; can you even imagine the cost of shipping in Interstate commerce without them?
What VC do for profits in the 3-5 year span, government must do for more generalized profits in the 20+ year span. That is the purpose of roads, bridges, a modernized energy grid, a high speed communications network and basic scientific research, especially in energy. The payoffs can be huge, but VC can't wait 20 or 40 years to reap them. Only government can tolerate that time scale.
Infrastructure - a whopping 3% of the bill. Now, THAT'S change we can believe in. It should create how many jobs?
I think this article used a lot of words to explain that venture capital and leveraged buyouts are completely different and should never be lumped together by investment funds. That is all well and good but venture firms will only be a small part of this economic recovery. Not unimportant just small.
"But at a time when we should be expanding VC funding...
You couldn't be more wrong. The skill sets needed to start new enterprises ARE hard to acquire, but there is no shortage out there contrary to your unsupported opinion. I think the author is exactly correct that there needs to be more money pumped into the VC and angel funded groups out there to support more innovation, more new company concepts. Baltotoast argues that eroding prices and margins is a horrible thing to be blamed on VC's -- huh? I thought prices dropping because of innovation and competition is the key to increasing productivity in a capitalist society.
I think the author's point is that only liquidity in the form of equity will truly jumpstart small businesses and new enterprises. The point is an excellent one and right on the money. In fact the Gov't should be investing bail out and stimulus money into VC funds (not PE, and not banks), and possibly even into stimulating IPO's for smaller companies.
It used to be that Wall Street was only about selling bonds and stocks in companies looking for capital. Wall Street has gone so far away from that model (not to mention Sarbanes Oxley's contributions) that an IPO exit for start-up companies is increasingly viewed as impossible.
Perhaps you misunderstand my point, perhaps you are uninformed. Perhaps both. Go to the NVCA website and check out how much money has 1) been raised for VC funds, 2) how much has been invested in companies and 3) how much has been returned to LPs. Compare this to historical norms. No one who knows this industry thinks the problem is a lack of capital to invest. The problem is excess capital funding me too companies.
Startups need a proprietary advantage that they can take advantage of to generate profits so they can become self sustainable, and attract growth capital. You confuse the ability to generate high margins at the enterprise level with lower prices for end users. The two should not be mutually exclusive and in the best of ventures they are not.
An IPO exit is viewed as impossible today - and SOX has something to do with it. But it also has to do with the current excesses of the VCs. And throwing more money at a broken business model is the wrong thing to do.
When Cisco went public (funded by VC) there were 10 companies that were competing to have their IOS become the industry standard (i.e. Wellfleet and Proteon). Cisco has been very reliant on the VC marketplace in funding many of it's acquisitions such as Cascade who brought them the Catalyst Switch. Kalpana, who brought the the ethernet switch. Stratcom that brought them the full range of WAN switches, and so on. Cisco has made a business of turning Venture Capital into Cisco stock.
All true, but about as relevant today as the Jurassic period. And Cisco did only one round of VC funding for around $5M, and never used the money.
sounds a lot like supply-side voodoo again. money doea not make magic. there must be tangible results and generated cash flow and feedback into the system. VC does not do that. it's sole purpose is to generate profit, not productivity.
Excellent essay, thanks.
Glad I didn't see "tax cut" in there. ;-)
Note that the Bankruptcy Bill -- that Joe Biden honcho'd on behalf of all those Delaware HQ'd financial firms -- is putting a damper on small business creation and survival. (NPR did a good piece on this post-Katri
There's VC-small..
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