Venture capital is an integral part of Silicon Valley. But how does venture actually work? Why is it so important to the tech industry—and what kind of tech industry has it created?
Where does innovation come from? Startups.
Where do startups come from? Venture capital.
For nearly half a century, this has been the conventional wisdom of Silicon Valley. Venture capital is the lifeblood of the Bay Area tech industry, ebbing and flowing with every business cycle. More broadly, venture has provided the initial form of financing for most of the world’s fifty most valuable publicly traded global corporations that were founded after the late 1960s. And it has become a standard part of how institutional investors allocate capital, from public employee pension funds to university endowments to wealthy families.
At present, venture capital deploys roughly $84 billion per year in the United States. And venture capital is no longer solely an American phenomenon. The model has been replicated all over the world, especially in burgeoning Asian tech ecosystems from Beijing to Bangalore.
Yet relatively few people understand how venture works or where it comes from.
Scaling to SurviveVenture capital needs scale to survive. It needs to fund companies that have the potential to become very big in order to compensate for losses or break-even returns elsewhere in a portfolio.
This need for scale is a key part of what distinguishes venture from other kinds of capital. Venture specializes in funding the development of unproven applications of technology—an endeavor that poses large risks with the potential for large rewards. Banks, commercial lenders, and traditional sources of capital for small businesses are highly restricted in the types of borrowers that they can afford to take risk on. Venture comes in to finance companies that traditional lenders can’t. And they do so through equity investments, rather than debt.
In exchange for assuming greater risk, venture firms expect higher returns. Its model tolerates losses—sometimes obscene ones—for a chance at grabbing an entire market or customer “mindshare” first.
Since some of the companies a VC fund invests in will fail, the ones that succeed must succeed big time. The venture model requires large, disproportionate returns from a handful of investments. About 6 percent of investments generate about 60 percent of venture capital’s total returns, according to a data set covering thirty years of returns from Horsley Bridge Partners, a firm that has invested in many well-known venture funds. Indeed, the larger the fund size or amount of capital under management, the larger the expectation of a big “exit”—an IPO or acquisition by another company.
A fund that has $100 million may only be able to justify investing in companies that seem likely to result in an exit that pays out $1 billion or more. And since most VC funds are structured as ten-year partnerships, they’re not only looking for big exits—they’re looking for big exits on schedule.
The VC model isn’t right for everyone. Many companies will never match the “return profile”—the rate of growth—required by venture capital. Moreover, for a startup, a venture check is only the beginning. Even though venture capital rounds are often celebrated as major milestones, they are really just entry tickets. When a company accepts venture funding, it commits itself to steep expectations for future growth. 2X a year is considered good, 3X is great, and 4X or more a year is amazing. These are challenging targets to meet, and the expectation to grow quickly can scale—but also contort—a founder’s original vision.
Taking venture funding can also involve surrendering a certain amount of control, although the way that venture firms exert influence varies widely. At an early-stage firm like the one where I work, we engage in so-called “soft advising.” By contrast, venture firms that invest at a later stage usually hold seats on the company’s board, and can therefore exercise “hard control.”
Sometimes this control is especially stark. In an earlier era, as many as 50 percent of original founders were thrown out in favor of professional management, according to an interview with Sequoia Capital founder Don Valentine. For the past decade, however, there has been a trend toward letting founders keep more power. The Facebook IPO set a new precedent by enabling Mark Zuckerberg to own most of the voting shares. Afterwards, venture firms marketed themselves as founder-friendly so as not to miss out on deals. But more recently, in the wake of the Uber crisis around Travis Kalanick, there is now some discussion that the industry has overcorrected toward too much founder control.
The Masters of the Masters of the Universe
To a startup founder seeking financing, venture capitalists might look like masters of the universe. But they answer to higher masters in the form of “limited partners.” These are the masters of the masters of the universe—venture capital’s customers, who supply most of the capital for a firm’s different funds.
Venture capitalists don’t just provide capital, in other words. They also have to raise it. A firm’s managers—called “general partners”—are responsible for finding limited partners to finance investments. They also often have to invest a meaningful amount of their personal wealth in the fund they work for, so that limited partners are assured they have skin in the game....MORE