In the following video provided by the Computer History Museum, industry pioneers Pitch Johnson and Reid Dennis talk about how the venture capital industry came about.
Now let's take a look at how venture capitalists operate today. Venture capital funds can be public or private (see Google Finance list of about 1000 funds). Some of the larger funds invest in 50 or more start-ups per year, and many of the private funds invest in roughly 5-30 companies per year. In Guy Kawasaki's presentation, he estimates that roughly 3000 companies receive venture capital in a given year, as opposed to millions of companies that get funded in other ways. VC funding comes from a lot of different sources-- pension funds, private investors, hedge funds, investment banks, etc.
Today, most of these sources, especially hedge funds who were way over-committed to risk with credit default swaps, are having serious issues in the current financial crisis. Those 3000 funded companies represented an aggregate of roughly $29 billion in 2008 and that will almost certainly decline going forward. As the industry unwinds its massive leverage to more reasonable ratios, the Angel and VC market will likely be smaller for quite a long time (see recent article). The good news is that many of those companies that were funded had similar business plans and this created an unnecessary redundancy within the start-up market.
Today, most of these sources, especially hedge funds who were way over-committed to risk with credit default swaps, are having serious issues in the current financial crisis. Those 3000 funded companies represented an aggregate of roughly $29 billion in 2008 and that will almost certainly decline going forward. As the industry unwinds its massive leverage to more reasonable ratios, the Angel and VC market will likely be smaller for quite a long time (see recent article). The good news is that many of those companies that were funded had similar business plans and this created an unnecessary redundancy within the start-up market.
John Talbott (see post) made an interesting observation regarding venture capitalists in his latest book The 86 Biggest Lies on Wall Street: "The number of success stories is so low in each case that to reward someone who has a 0.7 percent success ratio and to punish someone who has a 0.2 percent success ratio seems excessive."
If you are a statistics buff, you might be interested in the degrees of freedom and statistical significance of the success ratios of these funds-- if you're able to calculate it, please let me know. But the notion that a few funds are simply luckier than others does seem to gibe with common sense. There is an interesting book on this topic called Fooled by Randomness which is one man's (apparent) rationalization on why he didn't succeed-- which has led to his success. If you were an investor choosing among these VC funds, you may find that a quantitative approach to determine risk profiles is next to impossible because it is unclear which funds are better and which are luckier.
Having said that, I believe there are good funds out there though which have produced viable vetting processes and valuation techniques and who seem to find winners more often than the others. Typically, these funds have one or a few people involved who really know what they're doing. The bad funds are essentially legalized gambling-- with other people's money, of course. These funds often have one or two people who have 'made it' as an entrepreneur and supposedly know what they're doing too (again, see Fooled by Randomness). Many of these bad funds basically troll for companies. They parade through conferences, groups, and schools and offer complicated and sometimes usurious terms to unwitting do-gooders who are often just happy to have someone show interest in their idea.If you are a statistics buff, you might be interested in the degrees of freedom and statistical significance of the success ratios of these funds-- if you're able to calculate it, please let me know. But the notion that a few funds are simply luckier than others does seem to gibe with common sense. There is an interesting book on this topic called Fooled by Randomness which is one man's (apparent) rationalization on why he didn't succeed-- which has led to his success. If you were an investor choosing among these VC funds, you may find that a quantitative approach to determine risk profiles is next to impossible because it is unclear which funds are better and which are luckier.
VCs use essentially two methods to determine valuation: 1) the unimaginatively named 'Venture Capital Method', 2) the much more commonly used 'Comparables Method'. The former is really an intuitive guess backed up with a complicated report, and the latter is an intuitive guess backed up by someone else's analysis. It's kind of like a 'comp' for houses in your neighborhood where the venture capitalists look at similar deals to get an idea of how to value the company.
Some "venture capital" companies really act more like banks than the historical venture capitalists that Pitch Johnson and Reid Dennis talk about above. These funds focus on fairly well-established companies with good revenue who need an infusion of cash to take on larger contracts or gain market share. In these cases, the valuation methods do hold merit. But when you are talking about a company in the prototype or early stage without little or no revenues, then you are basically talking about guesses-- or bets-- backed up almost entirely with intuition.
Some "venture capital" companies really act more like banks than the historical venture capitalists that Pitch Johnson and Reid Dennis talk about above. These funds focus on fairly well-established companies with good revenue who need an infusion of cash to take on larger contracts or gain market share. In these cases, the valuation methods do hold merit. But when you are talking about a company in the prototype or early stage without little or no revenues, then you are basically talking about guesses-- or bets-- backed up almost entirely with intuition.
Talbott goes on to describe venture capitalists like this: "Venture capitalists are the classic example of a middleman. They really try not to benefit anyone other than themselves. If you have a good high-tech idea that you think will make you a lot of money and you bring it to a venture capital firm for a small infusion of capital, they will most likely end up grabbing a controlling position in the company and will eventually end up owning as much as 80 to 90 percent of your company. Your status will very quickly go from founder and owner to paid employee."
Sadly, this is true, but there are two sides to the story. The other side is entrepreneurs are seeking non-recourse money with sweat equity as collateral. It's a match made in heaven. If they take out a real loan, they have to pay it back or declare bankruptcy. Both the venture capitalist and the entrepreneur are using other people's money to gain potential upside value with little financial risk. The downside risk for both is that they close up shop and head on to something else which is exactly what is happening right now to a large number of peripheral firms. It is for this reason that I suggest that if you must get involved with venture capital, you do it with a firm that has a great reputation at stake. The same goes for an IPO-- choose an underwriter with a good reputation because they're less likely to jack up your starting price (more on that later). Probably the people who would most benefit from VC money are those who already have a viable, rapidly growing business but have hit a growth ceiling and don't have enough assets for a standard loan.
