There is this feeling among many founders and entrepreneurs that venture capital is the “dark side” and inherently evil. I have been very surprised to hear things like “we don’t want to go down the road with Vulture Capital” in the heart of venture capital in places like San Jose, Menlo Park, Mountain View, San Francisco, and Palo Alto. While I do agree that there are some bad apples, negative aspects of VCs and VC funding, and a general perception of VCs as sharks, I would argue that VCs are an invaluable part of the US economy and the use of VC funding has been extremely useful in the growth of many successful US companies.
Part of the problem is that people don’t understand exactly what VCs do and how VC works. The public only hears about a VC firm making billions off of an IPO and how VCs are like vultures that swoop in and take over the company and get rid of all existing employees. You can read my take on issues of company founders having a hard time giving up control here, but giving up some control is required in many situations to bring in the capital to make the company grow. Investors put money into a company to make money, not to make the world a better place. That is business 101.
Venture capitalists and many other types of investors analyze their investments carefully and there are reasons for the measures they take to protect their investment. People don’t often think about the 10,000 companies and sometimes hundreds of millions of dollars that a VC firm or other investors invest in to get 1 Facebook type of return. For example, last year, venture capital firms put in an estimated $28.6 billion into 3,673 deals/companies according to a recent VentureBeat article. That works out to an average of $7.8 million per deal. Let’s say on the high side, they see a return on 1/3, that is approximately $19.5 billion in lost investments.
Investing for anyone involves a calculation and analysis of risk versus return. When someone looks at their retirement and where they should invest their money, a good financial advisor will go through this analysis with them. If you are in your 20s and unmarried without kids, you are probably more willing to allocate your retirement to a little more risky opportunities with greater potential for return because you have time make up for any possible losses. However, if you are in your 50s and planning to retire in 10 years, you probably want to allocate the majority of your retirement to safe investments, despite their relatively low return. VCs are looking at anywhere from a year to maybe 5 years to get in and out. If you look at the types of companies that VCs fund, they are typically early stage or start-up companies. They target the potential for rapid growth and value creation in a short time frame. Then they want to create an exit to get out and monetize their return. This is often through mergers, acquisitions, leveraged buy outs, going public, and other forms of exit strategies. The chance of seeing a good return on investment through an exit is extremely low. VCs will fund tons of companies that inevitably go out of business and they end up losing their entire investment. That is the nature of the risky companies that they fund. Start-ups and early emerging growth companies are extremely risky and most do not make it past a few years.
The other aspect of venture capital firms that people don’t understand is that the VC firm is providing a service. Yes, the VC firm and the partners in their firm often put their own money into deals, but they often have limited partners that they have to report to. When you hear about a VC firm raising $100 million for their fund, you usually don’t know who put that money in, but those silent limited partners are demanding on what they want to see for a return as well. So the VC has others to be accountable to and need to take extra steps to try to assure the success of companies they fund.
Now there are ways to effectively use venture capital and still avoid some of what people consider the evil of the VC. One example is to look at Mark Zuckerberg and Facebook’s corporate development. Even up to the IPO, Mark still kept control over the company through board and management positions and voting agreements with other shareholders to have majority voting control. This was despite numerous rounds of VC and other sophisticated investment money coming into the company. The talk on the street was that he was not desperate when it came to funding and was able to set the terms of the funding.
There will always be negotiation and arguments over value of the company which usually determines the percentage of equity for the VC’s money and most VCs will want some control over their investment by putting their own trusted people on the board or in management. They will put restrictions and other conditions into the funding, but that is part of the price of getting the needed working capital to help the company make it to the next stage of their development. If you were putting millions of dollars into a brand new company with sometimes nothing more than an idea, wouldn’t you want the same large equity stake and control and oversight to help assist the company towards success and your ultimate return on investment? Why wouldn’t you want a partner who wants your company to succeed and has networks, connections, and experience to help with just about any challenge you face?
Venture capital has been and will continue to be a major factor in helping drive innovation and growth of new companies by providing the necessary funding at times when many other sources of capital would not even touch that risky of an investment. If you look at the majority of Fortune 1000 companies started within the last 30 years, you will see that they either took some form of venture capital at some stage of their development or currently rely on technology or other innovations that wouldn’t exist without the help of mistakenly called vulture capital.
[Updated 5/19] Just wanted to add a recent article I read and my take on it from Forbes.com that relates to this post:
Other articles of interest: