Venture capital is a type of private equity financing and seed funding option provided by investors to startups and small businesses with limited access to the equities and bonds markets but are deemed to have long-term growth potential. The entire practice remains an alternative source of funding, but it has been organized and formalized by creating venture capital firms and the professionalization of venture capitalists.
What is Venture Capital? Who Are the Venture Capitalists? What Do They Do?
Origins and Early History
The entire practice of providing funding to emerging businesses by private individuals existed even before the Second World War. However, it was the domain of wealthy individuals and families. For example, Laurence S. Rockefeller partly financed Eastern Air Lines and Douglas Aircraft in 1938 in the United States. The Wallenberg family established Investor AB in 1969 in Sweden as an investment and holding company that financed early Swedish companies such as Atlas Copco and Ericsson.
After the Second World War, interest in private equity funding grew further. Capitalists John Hay Whitney and Benno Schmidt founded J. H. Whitney & Company in 1946 as a private equity firm that focused primarily on acquisitions, recapitalizations, leveraged buyouts, and turnarounds of considerably matured companies and businesses in the middle market.
George Doriot, considered the father of venture capitalism, founded the American Research and Development Corporation in 1946 along with Ralph Flanders, an industrialist and politician, and Karl Compton, former MIT president. The organization promoted investing in emerging businesses established by soldiers who served during the Second World War.
The creation of the American Research and Development Corporation marked the emergence of new sources of private capital apart from wealthy families. Note that former employees of this organization also established their venture capital firms later in their careers. Examples include Greylock Partners, founded by Charlie Waite and Bill Elfers in 1965, and Charles River Ventures, founded by Richard Burnes in 1970.
Economic Impacts of Venture Capital
It cannot be denied that venture capital has an important role in the economy. For example, the research paper of P. A. Gompers mentioned that venture capitalists emerged further around the late 1970s in the United States and gained prominence during the 1980s. Note that large companies during the 1970s remained a potent force for influencing the growth and direction of the American economy.
However, during the 1980s, startup businesses and small companies were becoming considerably influential. The emergence of new businesses provided employment and fueled market competition. Some of these organizations were more innovative than larger and established ones. By the end of the 1980s and the start of the 1990s, millions of businesses emerged on a year-to-year basis. Similar to angel investments, venture capital provided funding for these businesses.
Private equity funding also became an alternative to initial public offerings and public equity trading after the stock market crashed in 1987. Foreign firms, including those coming from South Korea and Japan, flooded the U.S. market with capital for early-stage companies. It is also worth mentioning that alternative funding sources were also responsible for creating the technology industry in Silicon Valley.
The growing popularity of personal computers and the emergence of the Internet during the 1990s encouraged further the emergence of venture capitalists. Investors deemed the World Wide Web as a viable venture. Companies such as Amazon, Yahoo, and Netscape received financing from venture capital. More people either become venture capitalists or channeled their money to venture capital firms to access private equity investment. More businesses that sought to capitalize on the Internet also emerged as a result.
However, a number of online-enabled and online-based companies lacked potential. Several inexperienced private equity investors failed to evaluate the growth potential and business feasibility of these businesses. Hence, by the end of the 1990s, an economic bubble that was infamously referred to as the Internet or dot.com bubble emerged. The bursting of this bubble in 2000 caused a number of businesses and venture capital firms to fail.
Purpose, Functions, and Structure
Private equity financing remains popular today. Similar to angel investors, the modern purpose of venture capital is to provide an alternative to bank loans and financing through stock and bonds markets. However, it is worth mentioning that there are considerable differences between angel investors and venture capitalists.
Startup businesses and small companies seeking to expand require large sums of money to fund or finance the early stages of their ventures or projects. Expenses range from product research and development, mass production or mass service delivery, sustaining daily operations, and sales and marketing, among others.
Commercial banks used to be the primary source of funding or investment. However, not all entrepreneurs and emerging or small businesses can secure loans due to lack of collateral or assets, low credit ratings, and the presence of uncertainties. While angel investors can be an option, the funds they can contribute were usually insubstantial. Venture capitalists enter into the picture to fill that gaps.
Understanding further how venture capital works and functions requires understanding the structure of venture capital firms. Typically, venture capitalists follow a five-pronged process. These are: (1) soliciting or creating novel investment opportunities; (2) assessing companies or proposed business ventures; (3) negotiate the terms of investments; (4) assisting in the management or direction of the business; and (5) exiting through liquidation of investments.
Through the aforesaid activities, venture capitalists structure themselves as formal business organizations, usually as partnerships and general partnerships or as limited liability companies. Others pursue a joint venture arrangement with companies they intend to invest in. Their business operation revolves around looking for and buying shares from proposed business ventures and ideas that, upon careful assessment, would bring them profit either through capital appreciation, stock dividends, or by selling their shares.
Understanding Further Venture Capital as an Alternative Source of Funding
Venture capitalists are institutional investors. Like any other business, they are organizations subjected to the same laws and regulations pertaining to business operation, corporate law, and federal securities laws, among others. Nevertheless, it cannot be denied that the socioeconomic impacts of venture capital center on promoting economic growth by encouraging and supporting the building of successful business ventures.
Results from the survey of F. Dotzler revealed that startup businesses usually benefit from their venture capitalists, especially in the areas of leadership, operations management, and financial management. A related study also revealed that these investors play a role that transcends beyond mere sources of investments.
The active and dedicated participation of venture capitalists in small and emerging businesses contributes to the professionalization of these organizations. These investors can also be a source of competitive advantage not only because of the funding they provide but also through their managerial expertise. In certain situations, finding a suitable venture capital firm can be part of a market entry strategy because it can help a business expand its network and lower barriers to entry.
However, there are several appeals to regulate further the operations of venture capital firms. For example, in the wake of the 2008 Financial Crisis, observers and experts have recommended new policy directions and regulations applicable to the entire practice. More specifically, because of their macroeconomic and microeconomic impacts, newer policies should revolve around increasing further the regulatory authority of government agencies.
FURTHER READINGS AND REFERENCES:
- Anta, S. E.2008. Creative Capital: Georges Doriot and the Birth of Venture Capital. Harvard Business School Press. ISBN: 978-1-4221-0122-3.
- Dotzler, F. 2001. “What Do Venture Capitalists Really Do, and Where Do They Learn to Do It? The Journal of Private Equity.” 5(1): 6-12. DOI: 3905/jpe.2001.319997
- Gompers, P. A. 1994, “The Rise and Fall of Venture Capital.” Business and Economic History. 23(2). ISSN: 0849-6825. Available via PDF
