Chris Rizik - Post 2: What is Venture Capital?
Posted By: Chris Rizik
Posted: 6/26/2009
There are many people who claim to know about venture capital and are willing to give their well-formed opinions on its pros and cons; but more often than not the folks talking the loudest about venture capital have the most confusion about what it really is.
"Venture Capital" is defined by the National Venture Capital Association as "money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors." That’s a pretty good definition, but I would define it simply as active private equity investing in promising early stage companies. The key thing to remember is that, in the end, venture capital is about buying stock and later selling it for (hopefully) much more than the original purchase price; and if all goes right, helping a lot of people along the way.
• It is active because, unlike when you or I invest in the stock market, investing by venture capitalists requires regular and intense follow-up. It typically involves significant commitment to assist the investee company with business strategy, financial planning, recruiting talent and even operations. A good venture capital investor will have a solid understanding of best organizational practices, of the challenges in growing a young company, and of the industry in which the company operates.
• It is private equity financing, meaning that the investments are generally in companies that are closely held by a few investors and have stock that is not easily sold (there is no public market for the stock until much later, if at all). So the investment is made with the understanding that it will likely be long term. It is not unusual for a venture capital investment to be held from five to eight years before having some kind of event where the stock can be sold, such as an initial public offering or a sale of the company.
• Venture capital is generally invested in early stage companies, nearly all of which are not yet profitable. A large portion of these companies don't have revenue yet and many have not even created a product, but are still in the prototype or even "proof of concept" stage. Not exactly the type of companies where you and I would want to invest our 401(k)s.
Because of the nature of the investment and the nature of the companies in which it is invested, venture capital investing is high risk, high return investing. It is not unusual for one-third or more of the companies in which a venture capital firm invests to go out of business, yielding nothing to the investors. But venture capital investing is portfolio based, with investors anticipating that their best investments will yield many times the amount invested, more than making up for the "dogs" of the portfolio and yielding, on a total portfolio basis, an attractive rate of return. Historical investment returns have generally supported this thesis, as venture capital has typically outperformed the public stock markets by a significant margin.
Here's the most important takeaway: Despite all of the odd nomenclature and mystique that surrounds venture capital, in the end it is about buying and selling stock, and hopefully making significant gains in the process. The complications come principally due to the lack of marketability of the stock over most of its life, the high risk, high return nature of the investing and the speculative nature of the companies in which a venture capitalist invests.
A surprise to many people is that only rare companies are appropriate for venture capital investing. That is not a judgment that other companies are not good businesses, but is more of a statement about the nature and requirements of venture capital investment – that is, the goal of selling stock at tremendous gains within a specific time horizon. That is why venture capital is often most associated with breakthrough technologies, where risk is high but where, if the technology concept pans out, opportunity is even higher. There are many good – even great – companies that are simply not appropriate for venture capital for any of a number of reasons, such as (a) a rate of growth that is not as steep as venture capital requires, or (b) the lack of a realistic IPO or attractive acquisition of the company in the next 5-8 years.
But where venture capital is appropriate, success can mean great returns to venture capital investors and a plethora of high growth companies to a geographic region, paying high wages to a talented workforce. Venture capital success brings so many positives, it is rightly treated as the kind of economic home run for which every state in the country is shooting.
TOMORROW: THE ROLE OF VENTURE CAPITAL IN ADVANCING MICHIGAN