Venture Capital
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Industry Overview
The US venture capital industry includes about 900 companies with combined annual investments of about $26 billion and over $250 billion of investments under management. Major companies include Kleiner Perkins Caufield and Byers, New Enterprise Associates, and Technology Crossover Ventures. The industry is concentrated: the top 50 companies invest about two-thirds of venture capital dollars.
Competitive Landscape
Demand is driven primarily by the pace of technological innovation and the number of companies created to commercialize new technologies. The profitability of individual companies depends on successfully choosing and managing a portfolio of investments. Large companies have advantages in attracting investors, developing expertise in multiple technology markets, and funding large deals. Small companies can compete effectively by concentrating on specific market sectors or geographic areas. The average venture capital investment is about $8 million.
Individual, or angel, investors, and large companies with strategic interests in early stage companies are also sources of new venture funding.
Products, Operations & Technology
Venture capital companies provide money to young, rapidly growing companies with promising new products or services in exchange for ownership in the company. Major market sectors for venture capital investments include software; life sciences (including biotechnology and medical devices); telecommunications; media and entertainment; and clean tech (energy and environmental technologies).
Venture capitalists (VCs) create pools of money, or funds, by raising capital from pension funds, endowments, foundations, corporations, foreign investors, insurance companies, and high net worth individuals. A firm may operate several funds simultaneously.
Venture capital firms are organized as limited partnerships, limited liability partnerships (LLP), or limited liability companies (LLC). The most common form is the limited partnership, where the firm serves as the general partner and investors are limited partners. General partners operate the business on a daily basis, performing both fundraising and investment activities. General partners are paid a management fee for operating the fund, as well as a share of profits from the fund’s investment activities, known as “carried interest.” The terms and conditions of general partner compensation are spelled out in the fund’s prospectus.
The firm sets a target fund size and begins fundraising, which may range from weeks to several months. Once the target fund level is raised, the fund is closed and investment activity begins. Limited partners, the fund’s investors, may range from a few to less than 100, as a more restrictive set of regulations govern fundraising efforts when more than 100 investors are involved. General partners may also be limited partners in company funds. Capital calls, requests for investment dollars based on partner commitments, occur over the life of the fund’s investment activity, either as-needed or on a predetermined time frame.
VCs invest funds into companies using a portfolio approach. Recognizing the risky nature of venture capital investing, VCs anticipate high rates of return from their investments, knowing that not all portfolio companies will give them the expected return. VCs look for a portfolio company to have a liquidity event, such as an initial public offering (IPO), merger, or sale, within a three to seven year time horizon. Expected returns from this event are typically targeted at 10 times or more. Pre-money valuations, the value of a portfolio company before receiving venture capital, are determined by a combination of factors, including negotiations between company management and the VCs.
Venture capital investments are categorized in three stages: early stage or start-up funding, growth funding, and late stage funding, sometimes called mezzanine financing. A venture capital fund may participate in any or all, although most concentrate in a particular stage. The advantage to early stage investing is the lower valuation upon which the investment is based, providing the opportunity for a higher return. The advantage of later stage investing is the shorter time to a liquidity event and greater certainty of the company’s performance. If a venture capital company invests in an early round, it typically reserves funds to invest in later rounds. Fund sizes range from as little as $15 to $25 million for early stage funds to late stage funds of more than $500 million.
A venture capital firm may invest alone or may co-invest with other venture firms in a syndicated deal. Syndications are used when a company needs a large amount of capital or to bring in the market or technical expertise of other venture firms. Venture firms are actively involved in portfolio companies, and usually receive one or more seats on the company’s board of directors to protect and advance their investment.
Venture capital operations normally consist of general partners, partners, associates, entrepreneurs in residence, interns, and administrative personnel. Partners, unlike general partners, benefit only from the success of the specific portfolio companies they're involved with. Research and due diligence are critical components of the investment process. Many company business plans are reviewed by the operations staff, but only a very small percentage of reviewed companies are chosen for investment.