Financial Markets and Institutions (2-downloads)

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prudent man rule, which restricted pension funds from making risky investments,

to explicitly allow investment in some high-risk assets. This resulted in a surge of pen-

sion fund dollars going into venture projects.

Corporate funding of venture capital projects increased when many companies

reduced their investment in their own in-house R&D in favor of outside start-up com-

panies. If the project was successful, the company could acquire the start-up. This

change was fueled by evidence that many of the best ideas from in-house centralized

R&D languished unused or were commercialized in new firms started by defecting

employees. Salaried employees tend not to be as motivated as entrepreneurs who

stand to capture a large portion of the profits a new idea may generate. By invest-

ing in start-up firms, corporations can benefit from new discoveries while supporting

the entrepreneurial spirit.

Structure of Venture Capital Firms

Most early venture capital firms were organized

as closed-end mutual funds. A closed-end mutual fund sells a fixed number of shares

to investors. Once all of the shares have been sold, no additional money can be raised.

Instead, a new venture fund is established. The advantage of this organizational struc-

ture is that it provides the long-term money required for venture investing. Investors

cannot pull money out of the investment as they could from an open-end mutual fund.

In the 1970s and 1980s, venture capital firms began organizing as limited part-

nerships. This organizational structure is exempt from securities regulations, includ-

ing the burdensome disclosure requirements of the Investment Security Act of 1940.

While both organizational forms continue to be used, currently most venture capi-

tal firms are limited partnerships.

The Life of a Deal

Most venture capital deals follow a similar life cycle that begins

when a limited partnership is formed and funds are raised. In the second phase,

the funds are invested in start-up companies. Finally, the venture firm exits the

investment.

Next, we take a more detailed look at this process.

Fundraising

A venture firm begins by soliciting commitments of capital from investors.

As discussed, these investors are typically pension funds, corporations, and wealthy

individuals. Venture capital firms usually have a portfolio target amount that they

attempt to raise. The average venture fund will have from just a few investors up to 

100 limited partners. Because the minimum commitment is usually so high, venture

capital funding is generally out of reach of most average individual investors.

Once the venture fund begins investing, it will “call” its commitments from the

limited partners. These capital calls from the limited partners to the venture fund are

sometimes called “takedowns” or “paid-in-capital.” Venture firms typically call their

capital on an as-needed basis.

The limited partners understand that investments in venture funds are long-term.

It may be several years before the first investment starts to pay. In many cases, the

capital may be tied up for seven to 10 years. The illiquidity of the investment must

be carefully considered by the potential investor.

Investing

Once commitments have been received, the venture fund can begin the

investment phase. Venture funds may either specialize in one or two industry seg-

ments or may generalize, looking at all available opportunities. It is not uncommon

for venture funds to focus investments in a limited geographical area to make it eas-

ier to review and monitor the firms’ activities.

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Part 6 The Financial Institutions Industry

Frequently, venture capitalists invest in a firm before it has a real product or is

even clearly organized as a company. This is called seed investing. Investing in a

firm that is a little further along in its life cycle is known as early-stage investing.

Finally, some funds focus on later-stage investing by providing funds to help the

company grow to a critical mass to attract public financing.

Typically, about 60% of venture capital funds go into seed investments, 25%

into early-stage investments, and 15% into later-stage investments.

Exiting

The goal of a venture capital investment is to help nurture a firm until it

can be funded with alternative capital. Venture firms hope that an exit can be made

in no more than seven to 10 years. Later-stage investments may take only a few years.

Once an exit is made, the partners receive their share of the profits and the fund

is dissolved.

There are a number of ways for a venture fund to successfully exit an investment.

The most glamorous and visible is through an initial public offering. At the public

stock offering, the venture firm is considered an insider and receives stock in the

company, but the firm is regulated and restricted in how that stock can be sold or liq-

uidated for several years. Once the stock is freely tradable, usually after two years,

the venture fund distributes the stock to its limited partners, who may then hold

the stock or sell it. Over the last 25 years, over 3,000 companies financed by ven-

ture funds have had initial public offerings. During the peak years, there were

258 venture-backed initial public offerings.

While not as visible, an equally common type of successful exit for venture invest-

ments is through mergers and acquisitions. In these cases, the venture firm receives

stock or cash from the acquiring company. These proceeds are then distributed to

the limited partners. The number of venture-backed merger and acquisition deals

peaked at 269 in 2000.

Venture Fund Profitability

Venture investing is extremely high-risk. Most start-

up firms do not succeed. Despite the careful monitoring and advice provided by the

venture capital firm, there are innumerable hurdles that must be jumped before a

new concept or idea yields profits. If venture investing is high-risk, then there must

also be the possibility of a high return to induce investors to continue supplying funds.

Historically, venture capital firms have been very profitable, despite their high

risk. The 20-year average return is 23.4%. The 1990s were a wonderful time to be a

venture capitalist. The 10-year average return was 30%. From 1995 to 2000, the aver-

age return soared to over 50%.

In the late 1990s, venture capital returns continued to be extraordinary. For exam-

ple, returns exceeded 165% in 1999. Unfortunately, as the market cooled to technol-

ogy, so too did venture capital returns. By 2000, average returns were 37.5%, and in

2001, venture firms reported a first quarter loss of 8.9%. The venture capital market

suffered during the 2008–2009 recession as well, posting a 16.5% loss. The E-Finance

box discusses possible explanations for the losses suffered by venture capital firms.

Private Equity Buyouts

In the last section, we learned that new startup companies often fund their growth

by raising capital from venture capital firms. The private company is allowed to mature,

then, with profitability assured, it sells shares to the public. In a private equity