Venture Capital & the Finance of Innovation
Venture capital funding has long been a source of financing for entrepreneurs, breakthrough technologies, and start-ups. Venture capital backs companies, ideas, and products that carry significant risks and therefore may have difficulty securing more traditional sources of capital backing. Many of the innovative products and services that are supported by venture capital funding have very long development (time to market) cycles and are not appealing to investors seeking more immediate returns on their investment. Venture capital firms use specific and rigorous criteria to evaluate potential funding targets, and few proposed projects are actually able to secure financial backing. Venture capital funding is responsible for financing many innovations in information technology, biotechnology, life sciences, and health care. Venture capital firms seek out radically innovative ideas, what the industry terms disruptive technologies. Information technology, including computer technology and software applications, has been one area where VC funding has enabled the development of many digital age tools and applications. Health care and life sciences remain a favorite area of VC funding and the value of venture capital financing is well documented in the social and economic benefits that have come about through VC backing. Venture capital firms are only able to fund a fraction of the proposals that are made to their firms each year; entrepreneurs, researchers, and institutions are working to secure early financing from venture capital firms and other sources that will help to fund early stage ideas and projects.
Keywords Angel Investors; Bootstrap Funding; Disruptive Technologies; Entrepreneurs; Exit Strategy; Initial Public Offering (IPO); Liquidity Event; Small Business Investment Corporations (SBIC); Venture Capital; Viral Growth
Finance: Venture CapitalOverview
Venture capital (VC) funding makes an enormous contribution to US jobs, sales, economic growth, innovation, and technological progress. The funding that venture capital provides "nourishes the US economy by bringing innovative concepts and business models to life" ("Venture impact," 2007).
Venture capital financing provides support to innovative and cutting-edge companies in a variety of industry sectors. Some of the industry segments that have benefited the most from VC financing are:
- Computers and Peripherals;
- Retailing and Distribution;
- Financial Services;
- Health Care and Medical Devices.
Venture capital funding is truly unique in its support of entrepreneurial talent. VC funding provides access to "risk capital" that is not typically available from traditional financing sources such as banks. The projects that are particularly interesting to VC firms are quite different that what a bank might see as an ideal financial risk. VC-financed products, firms, and services "threaten" the status quo. VC firms are not looking for ideas that offer a marginal improvement on something that already exists; VC firms are looking for "disruptive technologies" that will provide completely new and innovative products and services. VC firms are also willing to wait for a return on their investment (often five to eight years). Today's more traditional capital markets are looking for much quicker returns, often quarterly, and are not willing to wait years to reap returns on their equity investments.
Another unique contribution that VC firms provide to emerging companies are professional managers who can become actively involved in the growth of the new company. Capital partners from VC firms typically sit on the board of directors of the new company, provide significant input, and also have significant influence in the strategic direction of the new venture. Typically, VC- financed projects are set up as a limited partnership (LP). Investors are limited partners and the firm itself is a general partner. Each unique fund or portfolio becomes a separate partnership.
Venture capital is raised from a number of sources to be invested in various business ventures. Funds are invested in high-growth businesses, and investors anticipate high returns on their investments because of the high risks. There are three general venture capital structures: Traditional venture capital firms (VC), small business interest corporations (SBIC) and angel investors. SBICs are privately owned and operated firms that partner with the federal government to provide venture capital to small businesses. SBICs will lend as little as $50,000 and are likely to offer more flexible terms than traditional VC firms. SBICs provide equity capital, long-term loans, and management assistance to small start-ups that might not be able to get the attention of larger VC firms.
Angel investors provide another type of venture capital (mostly to small businesses). Angel investors are typically single individuals who may be a family member, friend, or mentor of the person who is seeking funding for his or her small start-up. Angel investors are often entrepreneurs who enjoy helping out other small business owners and do so by investing their personal wealth in a start-up business. Angel investors, like all venture capitalists, are seeking high rates of return for their monetary investment, but angel investors are also aware of the high risk that such investment entails.
The third type of venture capitalist is typically associated with a VC firm (traditional VC firm) and will be the subject of this article. Traditional VC firms raise money from private sources that may include hedge funds, pension funds, endowments, insurance companies, foundations, banks, or individual investors. VC firms, on average, fund approximately 10 percent of the deals that their firms consider in a given year (Broome, 2007).
While banks tolerate a low risk/return paradigm, VC firms accept a lot more risk and will often take a 30 to 50 percent ownership stake in the funded company. VC firms also have a significant amount of "strategic involvement" in decision-making in the companies that they fund. Venture capital firms are also focused on an end goal that will culminate in a "liquidity event." A liquidity event is simply an exit strategy that will insure that the investor(s) are paid out completely, most often from the sale of the company through merger and acquisition activity or an initial public offering (Broome, 2007). Venture capital investment is not driven by transaction fees or quick returns. VC funded companies benefit all stakeholders with their success. Investors, employees, and company founders all stand to reap rewards if the VC-financed company is successful in the marketplace. However, it is estimated that 40 percent of VC-backed companies fail, 40 percent return modern amounts of capital, and only 20 percent or less produce high returns; however, these high returns generate most of the capital for VC firms.
Some of the most famous and successful companies in operation today were recipients of venture capital funding early in their development. Examples of companies that got their early funding with venture capital funds are: Microsoft, Intel, and Home Depot, and Medtronic. The economic impact of VC-backed firms is significant in many aspects. Consider the following (National Venture Capital Association, 2013):
- 11.87 million people were employed in jobs created as a result of VC financing in 2010.
- $3.1 trillion in revenue was generated in the United States in 2010.
- VC-financed companies accounted for 11 percent of US private sector Employment in 2010.
While venture capital investment is becoming a global phenomenon, it is instructive to examine why the United States has always been the most common location for this unique investment option.
The success of the VC model in the United States can be attributed to several factors ("Venture impact," 2007):
- An entrepreneurial spirit which is pervasive in the United States
- Financial recognition of success
- Access to strong science research and institutions.
- Open and fair capital markets
- Protection of intellectual property
- Access to a skilled workforce.
The National Venture Capital Association states that, “Venture capital is quite unique as an institutional investor asset class. When an investment is made in a company, it is an equity investment in a...
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