Venture Capital

Venture capital is a segment of the private l equity market that invests in young or high growth companies. Sometimes venture capital is used as a more general term that encompasses buyouts of existing firms, synonymous with private equity; this is especially common in Europe.

However, Gompers and Lerner (2001) have provided the traditional definition of the term: "independent, professionally managed, dedicated pools of capital that focus on equity or equity-linked investments in privately held, high growth companies".

The first part of this entry will describe the venture capital industry in the United States, where it originated and is most developed. The final section will discuss venture capital in other countries.

Venture capital firms invest in high risk, high reward ventures. Because these investments are illiquid—firms target investments that can take i ve or more years to mature—returns must compensate by being significantly higher than for publicly traded stocks.

Not all of these risky ventures are expected to succeed; venture capital firms do not seek a good return from each investment. Rather, they look for a small percentage of their portfolio, deemed home runs, to earn extraordinary returns and thereby create an excellent return for the over-all portfolio.

As each investment selected should show the potential to become a home run, venture capitalists seek investments that of er a potential annual return of greater than 50%.

This drives funding into high growth opportunities in high technology firms—communications, computers, biotechnology, and medical markets—or to companies with the potential to transform a large conventional industry, as FedEx did for shipping services and Staples did in retailing.

The venture capital industry began in 1946 in the United States when American Research and Development (ARD) was founded by New England area business leaders looking to encourage new economic development to replace the shrinking textile industry. ARD was the first firm to raise a pool of capital that was not based on family fortunes, and as such was the progenitor of the modern venture capital industry.

ARD is famous for the $70,000 investment they made in 1957 for a 77% stake in Digital Equipment Corporation that grew to a value of $355 million by 1971. This proved to be the industry’s first home run, and it provided half of ARD’s profits over its 25 year history. Many other home runs followed, including those of Apple Computer, Amazon, and Google, all of which have played an important part in this industry.

Although the venture capital market in the United States is the most developed in the world, it is still a relatively small market as venture capital firms invest annually in fewer than 2500 companies. Nonetheless, the venture capital industry in the United States has had a significant impact both on innovation and on economic growth.

Venture capital funding may be provided by banks, government agencies, corporate venture capital divisions, or wealthy individuals known as angels, but in the United States most venture capital is provided by limited partnerships.

The fund is a financial partnership, where the venture capital firm acts as the general partner, looking to raise money from investors and then to deploy this capital in promising start-up ventures.

The capital is provided by limited partners, either wealthy individuals or institutions (typically university endowments or pension funds), so named because their liability is limited to the amount that they contribute; they are restricted from actively participating in the management of the fund.

Venture capital firms raise a series of sequential funds, each accounted for separately, that are limited in both capital and time. Each limited partner agrees to provide a portion of the capital up to his/her prorata share of the maximum.

The fund is limited in time to 10 years (but extensions are frequently allowed); the first few years are focused on investing the capital and the latter years on harvesting the portfolio, converting the investments back to cash through the sale of the start-up companies to established firms or by taking them public.

In the 1960s, attempts to bring the venture capital model from the United States to other countries met with failure. Since then many studies have shown the importance of a number of elements necessary to support the creation of a venture capital market.

These include a well-developed legal system, access to capital markets so that investors can get liquidity, a workforce culture that allows for flexible recombinations, and government support in the form of favorable regulations as discussed in a series of essays in Kenney.

Around the world, governments have become more supportive of initiatives to encourage the development of local venture capital markets as a way to spur innovation and economic development. Since the 1990s venture capital has become well established both in Europe and Asia.

The most active overseas markets are found in London, Hong Kong, Israel, Taiwan, and Tokyo. Although there is some venture capital activity in almost every country around the world.

Globally, venture capital practices are not homogeneous. For example, in Europe venture capital statistics include management buyouts, and there is a much higher involvement by conventional banks.

As a percentage of GNP, venture capital investment is also much smaller in Europe and in Asia than in the United States, but the industry is developing rapidly, especially in China and India.

More recently there are signs that venture capital is becoming a global marketplace. Venture capital inflows and outflows have become quite significant, with many established firms starting offices and joint ventures in rapidly developing countries (Wright et al., 2005).

Venture Capital
Venture Capital
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