Financial Markets and Institutions (2-downloads)

Year

Number of Companies Funded

Investment Total ($ millions)

1990

1,317

3,376.21

1991

1,088

2,511.43

1992

1,294

5,177.56

1993

1,151

4,962.87

1994

1,191

5,351.18

1995

1,327

5,608.30

1996

2,078

11,278.60

1997

2,536

14,903.00

1998

2,974

21,090.60

1999

4,411

54,203.70

2000

6,342

104,986.80

2001

3,787

40,686.70

2002

2,617

21,824.00

2003

2,414

19,678.30

2004

2,571

22,117.40

2005

2,646

22,765.80

2006

3,746

26,315.36

2007

4,027

30,518.26

2008

3,985

27,992.29

2009

2,795

17,680.25

Source:

http://www.nvca.org/index.php

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560

Part 6 The Financial Institutions Industry

Venture capital firms can alleviate the information gap and thus allow firms to

receive financing they could not obtain elsewhere. First, as opposed to bank loans

or bond financing, venture capital firms hold an equity interest in the firm. The

firms are usually privately held, so the stock does not trade publicly. Equity inter-

ests in privately held firms are very illiquid. As a result, venture capital investment

horizons are long-term. The partners do not expect to earn any return for a num-

ber of years, often as long as a decade. In contrast, most investors in stocks are anx-

ious to see annual returns through either stock appreciation or dividend payouts.

They are often unwilling to wait years to see if a new idea, process, innovation,

or invention will yield profits. Similarly, most investors in bonds are not going to

wait years for revenues to grow to a point where interest payments become available.

Venture capital financing thus fills an important niche left vacant by alternative

sources of capital.

As a second method of addressing the asymmetric information problem, ven-

ture capital usually comes with strings attached, the most noteworthy being that

the partners in a venture capital firm take seats on the board of directors of the

financed firm. Venture capital firms are not passive investors. They actively attempt

to add value to the firm through advice, assistance, and business contacts. Venture

capitalists may bring together two firms that can complement each other’s activi-

ties. Venture capital firms will apply their expertise to help the firm solve various

financing and growth-related problems. The venture capital partners on the board

of directors will carefully monitor expenditures and management to help safeguard

the investment in the firm.

One of the most effective ways venture capitalists have of controlling managers

is to disburse funds to the company in stages only as the firm demonstrates progress

toward its ultimate goal. If development stalls or markets change, funds can be with-

held to cut losses.

Implicit to venture capital financing is an expectation of high risk and large

compensating returns. Venture capital firms will search very carefully among hun-

dreds of companies to find a few that show real growth potential. Despite this exhaus-

tive search effort, the selected firms usually have little to show initially other than

a unique and promising idea. Venture capitalists mitigate the risk by developing a

portfolio of young companies within a single fund. Additionally, many venture capi-

tal partnerships will manage multiple funds simultaneously. By diversifying the risk

among a number of start-up firms, the risk of loss is significantly lowered.

Origins of Venture Capital

The first true venture capital firm was American

Research & Development (ARD), established in 1946 by MIT president Karl Compton

and local business leaders. The bulk of their success can be traced to one $70,000

investment in a new firm, the Digital Equipment Company. This seed money grew

in value to $355 million over the next three decades.

2

During the 1950s and 1960s, most venture capital funding was for the develop-

ment of real estate and oil fields. By the late 1960s, a shift occurred toward financ-

ing technology start-ups. High technology remains the dominant area for venture

capital funding.

The source of venture capital funding has shifted from wealthy individuals to pen-

sion funds and corporations. In 1979, the U.S. Department of labor clarified the

2

Part of this discussion is based on “The Venture Capital Revolution,” by Paul Gompers and Josh

Lerner, Journal of Economic Perspectives, Number 2, Spring 2001, pp. 145–168.

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Chapter 22 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms