Venture Capital
Private equity is an industry that attracts professional risk takers. As such, they invest directly rather than lend money and target privately owned companies. As a result, these transactions are privately negotiated and they receive an equity stake for their investments. Of the different types of private equity, the most publicized is that of venture capital. Venture capital firms tend to focus on technology related companies, with some specializing in biotechnology. Much of the venture capitalists are based in Silicon Valley, although there is increasing presence in other parts of the US.
Venture capitalists help entrepreneurs start businesses and then sell those businesses to the public market in an initial public offering or to more established companies wishing to buy the start-up. According to Worth Magazine, venture capital is a $110 billion boys' club, albeit there are more women getting into the business. On a profit basis, all venture capital profits are bigger than the combined profits of the aerospace, entertainment and automobile industries. Why such an industry has been kept secret arises out of the Securities Act of 1933, when the law was intended to protect the life savings of working Americans. As such, only individuals with more than $1 million in assets or those with incomes of $200,000 in each of the past two years or $300,000 in combination with a spouse can qualify to invest in private offerings. With over $20 billion in profits and fewer than 3,000 workers, the venture capital industry remains little familiar to most Americans, however that is changing.
Venture capitalists (VCs) are among the most powerful Americans who fuel the economic boom of recent years. Some notable VCs include Don Valentine(funded Apple, Oracle, and Cisco), John Doerr (funded Compaq, Lotus, Sun and Amazon), Michael Moritz (funded Yahoo), and Ann Winbald. Winbald, one of the most respected VC has a 55% averaged annualized return on investment, net of expenses, for the last ten years while common stocks have returned about 19%.
Venture funds are usually set up as limited partnerships that use money from corporations and from traditional institutional investors such as insurance companies and pension funds to fund start-ups. The VCs who run these funds are the general partners who receive a management fee based on the size of the fund (about 2-3% of the fund's value per year). For example, Kleiner Perkins Caufield & Byers manages $2 billion and receives an annual fee of $40 million to support a staff of 35. In addition, VCs such as Kleiner Perkins also take about 30% of the profits that are above the stated goal of the venture fund.
According to Pricewaterhouse, venture capital investments for the first quarter of 2000 set records both nationally at $17.22 billion and in the Bay area at $6.13 billion. Of the $17.2 billion invested in 1,423 start-ups, about 63% went to technology companies such as internet-related businesses and net infrastructure companies, an increase from 45% in the same period last year.
The Bay Area continues to be the center of VC funding with about 36% of all venture capital invested in the first quarter of 2000. However, funding for the Bay Area grew by only 8% as compared with the Midwest’s 70% and New England’s 52% increase in venture investment over the same period.
Historically, average returns for venture capital funds are in the high teens and low twenties, the one-year return for 1999 was a whopping 146.2%, according to Venture Economics and the National Venture Capital Association.
In order to attract venture funding, your product or service and company are going to need to be very special. Most venture firms focus on emerging technologies and are solely interested in companies that have proprietary products or services. Retail or consumer deals are of interest only if they represent a strong national or international potential.
According to the "Small Business Guide to Financing", the following are some criteria for attracting venture funding:
1) Proprietary product or services. Companies with proprietary products or services including patents, trademarks, copyrights, or other special rights may protect a company’s unique position in the market. The company should have some significant advantage over existing or potential competitors so it can achieve and remain dominant in its industry.
2) Huge Market Potential. Venture funded companies are expected to grow to $30, $50 and $100 million in 5-7 years. As such, the industry has to be large enough to enable such growth potential.
3) Proven Management Team. Management is the most important factor in the venture capitalist’s decision to invest in your company. Can you grow the company in the next few years? Can you hire the required top talent in your field?
4) Extraordinary Returns. Venture capitalists are looking for 35-50% returns or even higher returns.
Upon making an investment, most firms will take a position on the Board of Directors and actively add value to the company in that role. Finally, they exit the investment usually through an initial public offering or the company is sold to a more establish company.
Although funding remains one of the most important needs of a start-up, the venture capitalist role has evolved over time with increasing pressure to be a one-stop shop for start-ups. Today, the venture capital firm usually holds a board of director seat allowing the VC to contribute to management. Due to the tight labor market and great demand for certain job functions, the VC has been known to recruit top professional management teams for the start-up using the VC’s personal network. The VC network of firms is also an added advantage when searching for the right VC partnership/funding, as business alliances are increasingly important in our global economy. VC partners also tend to former CEOs and founders of companies themselves, allowing the VC to share their past experiences with the current company management to avoid similar mistakes. Finally, the stature of the VC firm allows the public market in an initial public offering to value the stock significantly more than a less prestigious VC backing. These are some of the functions of today’s VCs in addition to the necessary capital they provide start-ups.
With the proliferation of more VCs, there will be more money for start-ups, especially for high-tech start-ups. At the same time, more start-ups will result in more failures and thus the rate of return of VC funds will normalize over time. Meanwhile, the economic and technological change will increase with the overall increase in funding. While the average American became familiar with the stock market in the last few decades and invested in mutual funds, more Americans will become familiar with venture capital and private equity funds and hence become investors in these funds in the near future.
As the number of women business owners continue to grow and the number of women VCs continue to grow, perhaps there will be more VC funding women-owned businesses. In addition, with more organizations (such as AWIB) providing a forum to educate women business owners on VC funding and other financing possibilities there will be more women business owners knowledgeable about the funding process. Finally, with more and more successful business women around, women can create their own funding vehicle through establishing their own venture capital fund or becoming angel investor is other women owned businesses. The bottom line is that—the return on investment has to be worth the risk taken by any VC-be it run by men, women or otherwise.
Source: The Money Tree, PricewaterhouseCoopers, Mercury News
This article was written by To Trinh Quan, Esq, June 2000