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Invention and innovation bulldoze the U.Southward. economy. What's more, they have a powerful grip on the nation'southward collective imagination. The popular press is filled with confronting-all-odds success stories of Silicon Valley entrepreneurs. In these sagas, the entrepreneur is the modernistic-day cowboy, roaming new industrial frontiers much the aforementioned way that earlier Americans explored the West. At his side stands the venture capitalist, a trail-wise sidekick ready to help the hero through all the tight spots—in commutation, of form, for a slice of the activeness.

Equally with most myths, there's some truth to this story. Arthur Stone, Tommy Davis, Tom Perkins, Eugene Kleiner, and other early on venture capitalists are legendary for the parts they played in creating the mod computer industry. Their investing knowledge and operating experience were as valuable every bit their capital. Just as the venture uppercase business organization has evolved over the past 30 years, the image of a cowboy with his sidekick has get increasingly outdated. Today's venture capitalists look more than like bankers, and the entrepreneurs they fund look more like M.B.A.'due south.

The U.S. venture-majuscule manufacture is envied throughout the world every bit an engine of economic growth. Although the commonage imagination romanticizes the industry, separating the popular myths from the current realities is crucial to agreement how this important slice of the U.Due south. economy operates. For entrepreneurs (and would-be entrepreneurs), such an analysis may prove especially benign.

Venture Majuscule Fills a Void

Contrary to popular perception, venture upper-case letter plays but a pocket-size role in funding bones innovation. Venture capitalists invested more $10 billion in 1997, but only 6%, or $600 million, went to startups. Moreover, we estimate that less than $1 billion of the full venture-capital puddle went to R&D. The majority of that capital went to follow-on funding for projects originally developed through the far greater expenditures of governments ($63 billion) and corporations ($133 billion).

Where venture money plays an important role is in the next stage of the innovation life cycle—the period in a visitor's life when it begins to commercialize its innovation. We estimate that more than 80% of the money invested past venture capitalists goes into edifice the infrastructure required to grow the business—in expense investments (manufacturing, marketing, and sales) and the residual sheet (providing stock-still avails and working majuscule).

Venture coin is not long-term coin. The idea is to invest in a company's balance canvas and infrastructure until information technology reaches a sufficient size and credibility so that it tin can exist sold to a corporation or and then that the institutional public-disinterestedness markets tin can step in and provide liquidity. In essence, the venture capitalist buys a stake in an entrepreneur's idea, nurtures it for a brusque period of fourth dimension, and then exits with the assistance of an investment banker.

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Venture majuscule's niche exists because of the structure and rules of capital markets. Someone with an idea or a new technology often has no other institution to turn to. Usury laws limit the interest banks can charge on loans—and the risks inherent in starting time-ups usually justify higher rates than allowed by constabulary. Thus bankers volition just finance a new business to the extent that there are hard assets against which to secure the debt. And in today's data-based economic system, many showtime-ups take few difficult assets.

Furthermore, investment banks and public disinterestedness are both constrained by regulations and operating practices meant to protect the public investor. Historically, a company could non admission the public market without sales of about $15 million, assets of $ten meg, and a reasonable profit history. To put this in perspective, less than two% of the more than than 5 million corporations in the United States accept more than $10 million in revenues. Although the IPO threshold has been lowered recently through the issuance of evolution-stage company stocks, in general the financing window for companies with less than $10 meg in revenue remains closed to the entrepreneur.

Venture capital fills the void between sources of funds for innovation (chiefly corporations, government bodies, and the entrepreneur'due south friends and family) and traditional, lower-price sources of capital available to ongoing concerns. Filling that void successfully requires the venture capital manufacture to provide a sufficient return on capital to concenter individual equity funds, bonny returns for its ain participants, and sufficient upside potential to entrepreneurs to attract high-quality ideas that will generate high returns. Put simply, the challenge is to earn a consistently superior return on investments in inherently risky business organization ventures.

Sufficient Returns at Acceptable Hazard

Investors in venture capital funds are typically very large institutions such as alimony funds, financial firms, insurance companies, and university endowments—all of which put a pocket-sized pct of their total funds into high-risk investments. They expect a return of betwixt 25% and 35% per year over the lifetime of the investment. Because these investments represent such a tiny part of the institutional investors' portfolios, venture capitalists have a lot of latitude. What leads these institutions to invest in a fund is not the specific investments simply the firm'southward overall track record, the fund's "story," and their confidence in the partners themselves.

How do venture capitalists meet their investors' expectations at acceptable risk levels? The answer lies in their investment profile and in how they structure each deal.

The Investment Profile.

One myth is that venture capitalists invest in good people and good ideas. The reality is that they invest in good industries—that is, industries that are more competitively forgiving than the market place as a whole. In 1980, for example, nearly twenty% of venture capital investments went to the free energy industry. More recently, the catamenia of capital has shifted rapidly from genetic engineering, specialty retailing, and reckoner hardware to CD-ROMs, multimedia, telecommunication, and software companies. At present, more than 25% of disbursements are devoted to the Internet "space." The credible randomness of these shifts amidst technologies and industry segments is misleading; the targeted segment in each instance was growing fast, and its capacity promised to be constrained in the next v years. To put this in context, we estimate that less than 10% of all U.S. economic activity occurs in segments projected to grow more than xv% a twelvemonth over the side by side five years.

The myth is that venture capitalists invest in adept people and practiced ideas. The reality is that they invest in good industries.

In issue, venture capitalists focus on the middle part of the archetype industry S-curve. They avoid both the early on stages, when technologies are uncertain and market place needs are unknown, and the later stages, when competitive shakeouts and consolidations are inevitable and growth rates slow dramatically. Consider the disk drive industry. In 1983, more than 40 venture-funded companies and more 80 others existed. By late 1984, the industry marketplace value had plunged from $5.4 billion to $1.4 billion. Today only five major players remain.

Growing inside loftier-growth segments is a lot easier than doing and so in low-, no-, or negative-growth ones, as every businessperson knows. In other words, regardless of the talent or charisma of individual entrepreneurs, they rarely receive backing from a VC if their businesses are in depression-growth market place segments. What these investment flows reflect, then, is a consistent pattern of capital resource allotment into industries where most companies are likely to look adept in the near term.

During this adolescent period of high and accelerating growth, it can be extremely hard to distinguish the eventual winners from the losers because their financial functioning and growth rates look strikingly similar. (See the nautical chart "Timing Is Everything.") At this phase, all companies are struggling to deliver products to a product-starved market. Thus the critical challenge for the venture backer is to identify competent management that can execute—that is, supply the growing demand.

Timing Is Everything.

More than eighty% of the coin invested past venture capitalists goes into the adolescent phase of a company'south life wheel. In this period of accelerated growth, the financials of both the eventual winners and losers look strikingly similar.

Picking the wrong manufacture or betting on a technology risk in an unproven market place segment is something VCs avoid. Exceptions to this rule tend to involve "concept" stocks, those that hold peachy hope just that have an extremely long time to succeed. Genetic applied science companies illustrate this signal. In that industry, the venture backer's claiming is to place entrepreneurs who tin can advance a fundamental engineering science to a certain stage—FDA approval, for example—at which indicate the company can be taken public or sold to a major corporation.

Past investing in areas with high growth rates, VCs primarily consign their risks to the ability of the company's management to execute. VC investments in high-growth segments are probable to accept exit opportunities because investment bankers are continually looking for new loftier-growth bug to bring to marketplace. The bug will be easier to sell and likely to support high relative valuations—and therefore high commissions for the investment bankers. Given the risk of these types of deals, investment bankers' commissions are typically half-dozen% to eight% of the money raised through an IPO. Thus an attempt of but several months on the part of a few professionals and brokers can result in millions of dollars in commissions.

As long every bit venture capitalists are able to get out the company and industry before it tops out, they can reap extraordinary returns at relatively depression hazard. Acute venture capitalists operate in a secure niche where traditional, depression-cost financing is unavailable. Loftier rewards tin be paid to successful management teams, and institutional investment will be available to provide liquidity in a relatively brusque period of time.

The Logic of the Deal.

There are many variants of the basic bargain construction, but whatever the specifics, the logic of the bargain is always the same: to give investors in the venture capital fund both aplenty downside protection and a favorable position for additional investment if the visitor proves to exist a winner.

In a typical start-up deal, for example, the venture uppercase fund volition invest $3 one thousand thousand in exchange for a 40% preferred-disinterestedness buying position, although contempo valuations take been much higher. The preferred provisions offer downside protection. For case, the venture capitalists receive a liquidation preference. A liquidation feature simulates debt past giving 100% preference over mutual shares held by management until the VC's $iii one thousand thousand is returned. In other words, should the venture fail, they are given outset claim to all the company's assets and technology. In addition, the bargain frequently includes blocking rights or disproportional voting rights over cardinal decisions, including the auction of the company or the timing of an IPO.

The contract is besides likely to contain downside protection in the form of antidilution clauses, or ratchets. Such clauses protect against equity dilution if subsequent rounds of financing at lower values take place. Should the company stumble and take to raise more coin at a lower valuation, the venture firm will exist given plenty shares to maintain its original equity position—that is, the total percent of equity owned. That preferential treatment typically comes at the expense of the mutual shareholders, or management, as well as investors who are not affiliated with the VC business firm and who practice not go along to invest on a pro rata basis.

Alternatively, if a visitor is doing well, investors enjoy upside provisions, sometimes giving them the right to put additional money into the venture at a predetermined price. That means venture investors can increase their stakes in successful ventures at beneath marketplace prices.

How the Venture Capital Industry Works.

The venture capital industry has four main players: entrepreneurs who need funding; investors who desire high returns; investment bankers who need companies to sell; and the venture capitalists who brand coin for themselves by making a market place for the other 3.

VC firms also protect themselves from risk by coinvesting with other firms. Typically, at that place will be a "lead" investor and several "followers." It is the exception, not the rule, for one VC to finance an individual visitor entirely. Rather, venture firms adopt to have two or three groups involved in nigh stages of financing. Such relationships provide further portfolio diversification—that is, the ability to invest in more deals per dollar of invested capital letter. They too decrease the workload of the VC partners by getting others involved in assessing the risks during the due diligence menstruation and in managing the deal. And the presence of several VC firms adds credibility. In fact, some observers have suggested that the truly smart fund will always be a follower of the top-tier firms.

Attractive Returns for the VC

In return for financing one to two years of a company's outset-up, venture capitalists expect a x times return of uppercase over five years. Combined with the preferred position, this is very high-cost capital: a loan with a 58% annual compound interest rate that cannot be prepaid. But that rate is necessary to deliver average fund returns in a higher place 20%. Funds are structured to guarantee partners a comfortable income while they work to generate those returns. The venture capital letter partners concur to return all of the investors' capital before sharing in the upside. However, the fund typically pays for the investors' annual operating upkeep—2% to 3% of the pool's total majuscule—which they take as a direction fee regardless of the fund's results. If there is a $100 meg puddle and four or five partners, for example, the partners are essentially assured salaries of $200,000 to $400,000 plus operating expenses for 7 to ten years. (If the fund fails, of course, the group will be unable to raise funds in the time to come.) Compare those figures with Tommy Davis and Arthur Stone's first fund, which was $5 1000000 but had a total management fee of only $75,000 a yr.

The real upside lies in the appreciation of the portfolio. The investors get 70% to 80% of the gains; the venture capitalists get the remaining twenty% to xxx%. The amount of money whatsoever partner receives beyond bacon is a office of the total growth of the portfolio'south value and the amount of money managed per partner. (See the exhibit "Pay for Performance.")

Pay for Performance.

Thus for a typical portfolio—say, $twenty million managed per partner and 30% total appreciation on the fund—the boilerplate annual bounty per partner volition be about $2.4 million per year, near all of which comes from fund appreciation. And that compensation is multiplied for partners who manage several funds. From an investor'southward perspective, this compensation is acceptable because the venture capitalists have provided a very bonny return on investment and their incentives are entirely aligned with making the investment a success.

What part does the venture backer play in maximizing the growth of the portfolio'due south value? In an ideal globe, all of the firm's investments would be winners. Merely the earth isn't platonic; even with the best direction, the odds of failure for any individual company are high.

On average, expert plans, people, and businesses succeed but one in 10 times. To see why, consider that there are many components critical to a visitor's success. The best companies might have an 80% probability of succeeding at each of them. Simply even with these odds, the probability of eventual success will be less than 20% because failing to execute on whatsoever ane component can torpedo the entire visitor.

If simply 1 of the variables drops to a 50% probability, the combined hazard of success falls to 10%.

These odds play out in venture capital letter portfolios: more than half the companies will at best return merely the original investment and at worst be total losses. Given the portfolio approach and the bargain structure VCs utilize, however, merely ten% to 20% of the companies funded need to exist real winners to achieve the targeted return rate of 25% to xxx%. In fact, VC reputations are often built on one or two good investments.

A typical breakout of portfolio performance per $one,000 invested is shown beneath:

Those probabilities as well have a bully impact on how the venture capitalists spend their time. Little fourth dimension is required (and sometimes best not spent) on the existent winners—or the worst performers, called numnuts ("no money, no time"). Instead, the VC allocates a pregnant amount of time to those eye portfolio companies, determining whether and how the investment can be turned around and whether continued participation is appropriate. The equity ownership and the deal structure described earlier give the VCs the flexibility to brand management changes, specially for those companies whose performance has been mediocre.

About VCs distribute their time amid many activities (see the exhibit "How Venture Capitalists Spend Their Fourth dimension"). They must place and attract new deals, monitor existing deals, allocate additional majuscule to the most successful deals, and assistance with exit options. Astute VCs are able to allocate their time wisely among the various functions and deals.

How Venture Capitalists Spend Their Time

Assuming that each partner has a typical portfolio of 10 companies and a 2,000-hour piece of work year, the amount of time spent on each visitor with each activity is relatively small-scale. If the total time spent with portfolio companies serving every bit directors and interim as consultants is twoscore%, and so partners spend 800 hours per year with portfolio companies. That allows merely 80 hours per year per company—less than 2 hours per week.

The pop image of venture capitalists as sage advisors is at odds with the reality of their schedules. The financial incentive for partners in the VC firm is to manage every bit much money as possible. The more money they manage, the less time they accept to nurture and advise entrepreneurs. In fact, "virtual CEOs" are now being added to the equity puddle to counsel company management, which is the role that VCs used to play.

Today's venture capital fund is structurally similar to its late 1970s and early 1980s predecessors: the partnership includes both limited and general partners, and the life of the fund is seven to x years. (The fund makes investments over the form of the offset two or three years, and whatever investment is active for up to v years. The fund harvests the returns over the last two to three years.) However, both the size of the typical fund and the corporeality of coin managed per partner accept changed dramatically. In 1980, the average fund was about $20 million, and its two or 3 full general partners each managed three to 5 investments. That left a lot of time for the venture uppercase partners to work directly with the companies, bringing their experience and industry expertise to comport. Today the boilerplate fund is ten times larger, and each partner manages two to five times equally many investments. Not surprisingly, then, the partners are usually far less knowledgeable almost the industry and the applied science than the entrepreneurs.

The Upside for Entrepreneurs

Even though the structure of venture capital deals seems to put entrepreneurs at a steep disadvantage, they go along to submit far more plans than actually get funded, typically by a ratio of more than 10 to one. Why practice seemingly bright and capable people seek such high-price upper-case letter?

Venture-funded companies attract talented people by appealing to a "lottery" mentality. Despite the high risk of failure in new ventures, engineers and businesspeople leave their jobs because they are unable or unwilling to perceive how risky a start-upwards tin can be. Their state of affairs may be compared to that of hopeful high school basketball game players, devoting hours to their sport despite the overwhelming odds against turning professional person and earning 1000000-dollar incomes. But perhaps the entrepreneur'due south behavior is not then irrational.

Consider the options. Entrepreneurs—and their friends and families—ordinarily lack the funds to finance the opportunity. Many entrepreneurs also recognize the risks in starting their ain businesses, so they shy abroad from using their own money. Some likewise recognize that they do not possess all the talent and skills required to abound and run a successful business.

About of the entrepreneurs and management teams that outset new companies come from corporations or, more than recently, universities. This is logical considering nearly all bones research money, and therefore invention, comes from corporate or government funding. But those institutions are better at helping people detect new ideas than at turning them into new businesses (see the exhibit "Who Else Funds Innovation?"). Entrepreneurs recognize that their upside in companies or universities is limited by the institution'south pay structure. The VC has no such caps.

Downsizing and reengineering take shattered the historical security of corporate employment. The corporation has shown employees its version of loyalty. Good employees today recognize the inherent insecurity of their positions and, in return, have lilliputian loyalty themselves.

Additionally, the United States is unique in its willingness to embrace risk-taking and entrepreneurship. Unlike many Far Eastern and European cultures, the culture of the U.s.a. attaches fiddling, if whatever, stigma to trying and failing in a new enterprise. Leaving and returning to a corporation is often rewarded.

For all these reasons, venture capital is an attractive deal for entrepreneurs. Those who lack new ideas, funds, skills, or tolerance for risk to offset something lone may be quite willing to be hired into a well-funded and supported venture. Corporate and academic grooming provides many of the technological and business skills necessary for the task while venture capital contributes both the financing and an economic reward structure well beyond what corporations or universities afford. Even if a founder is ultimately demoted as the visitor grows, he or she tin still get rich because the value of the stock will far outweigh the value of any forgone bacon.

By understanding how venture capital actually works, acute entrepreneurs can mitigate their risks and increase their potential rewards. Many entrepreneurs brand the mistake of thinking that venture capitalists are looking for expert ideas when, in fact, they are looking for good managers in particular manufacture segments. The value of any individual to a VC is thus a function of the following weather condition:

  • the number of people within the high-growth industry that are qualified for the position;
  • the position itself (CEO, CFO, VP of R&D, technician);
  • the match of the person'south skills, reputation, and incentives to the VC firm;
  • the willingness to take risks; and
  • the ability to sell oneself.

Entrepreneurs who satisfy these atmospheric condition come up to the tabular array with a strong negotiating position. The ideal candidate will also have a business organization rails tape, preferably in a prior successful IPO, that makes the VC comfy. His reputation will be such that the investment in him will be seen every bit a prudent risk. VCs want to invest in proven, successful people.

Merely like VCs, entrepreneurs need to make their own assessments of the manufacture fundamentals, the skills and funding needed, and the probability of success over a reasonably short time frame. Many excellent entrepreneurs are frustrated by what they see as an unfair deal process and disinterestedness position. They don't sympathize the basic economics of the venture business concern and the lack of financial alternatives available to them. The VCs are usually in the position of power past being the only source of uppercase and past having the ability to influence the network. Only the lack of good managers who can deal with uncertainty, high growth, and high risk can provide leverage to the truly competent entrepreneur. Entrepreneurs who are sought later on by competing VCs would be wise to ask the following questions:

  • Who will serve on our board and what is that person'southward position in the VC business firm?
  • How many other boards does the VC serve on?
  • Has the VC always written and funded his or her own business program successfully?
  • What, if whatever, is the VC'due south directly operating or technical experience in this industry segment?
  • What is the firm's reputation with entrepreneurs who have been fired or involved in unsuccessful ventures?

The VC partner with solid experience and proven skill is a true "trail-wise sidekick." Most VCs, however, have never worked in the funded industry or have never been in a downwards bike. And, unfortunately, many entrepreneurs are self-absorbed and believe that their own ideas or skills are the central to success. In fact, the VC's financial and concern skills play an of import role in the company'south eventual success. Moreover, every company goes through a life wheel; each stage requires a different ready of management skills. The person who starts the business is seldom the person who tin grow it, and that person is seldom the one who can lead a much larger company. Thus it is unlikely that the founder will exist the aforementioned person who takes the company public.

Ultimately, the entrepreneur needs to evidence the venture capitalist that his squad and idea fit into the VC's current focus and that his disinterestedness participation and direction skills will make the VC'south job easier and the returns college. When the entrepreneur understands the needs of the funding source and sets expectations properly, both the VC and entrepreneur tin profit handsomely.• • •

Although venture capital has grown dramatically over the by ten years, it nonetheless constitutes simply a tiny part of the U.S. economy. Thus in principle, it could grow exponentially. More likely, however, the cyclical nature of the public markets, with their historic booms and busts, will check the industry'south growth. Companies are at present going public with valuations in the hundreds of millions of dollars without ever making a penny. And if history is any guide, about of these companies never will.

The system described here works well for the players it serves: entrepreneurs, institutional investors, investment bankers, and the venture capitalists themselves. It also serves the supporting cast of lawyers, advisers, and accountants. Whether it meets the needs of the investing public is still an open question.

A version of this article appeared in the November-December 1998 outcome of Harvard Business concern Review.