1 V. VENTURE CAPITAL FIRMS A. An Introduction to Venture Capital
V. VENTURE CAPITAL FIRMS
A. An Introduction to Venture Capital
A venture capital firm (VC) is a financial intermediary that invests capital in
private portfolio companies. The typical VC such as Charles River Associates or Matrix
Partners is a private equity firm with a limited partnership structure. The VC will
typically invest in the illiquid securities of a portfolio firm in an early stage of its
existence. The private equity characteristic frees the VC of much of the regulatory
burdens faced by public firms while the limited liability partnership structure enables the
VC to obtain capital from investors without exposing them to liabilities of the target
firms. The markets for initial public offerings (IPOs) provide crucial exit routes for
venture capital (VC) investment, while venture capitalists provide an important source of
supply for IPO markets. In most cases, VC firms will maintain active roles in the
monitoring, management and governance of the firms in which they invest. Angel
investors are similar in many respects to VC firms except that they are individuals rather
than limited liability partnerships.
The National Venture Capital Association reported that in 2004, there were 897
VC firms with 1678 funds 9239 principals and $260.7 billion in capital. The Association
also stated that in 2003, venture capital funded companies were directly responsible for
more than 10 million U.S. jobs and $1.8 trillion in U.S. company sales in 2003. The
typical VC is a small firm, with about 10 general partners, and each fund has a larger
number of limited partners, mostly institutional investors. Limited partners commit a
specified level of capital from which the fund draws to invest in portfolio companies. The
typical VC firm will have a number of distinct funds in various investment periods, and
the typical life span of a fund is about 10 years. Funds typically close to new investors
after achieving their fund-raising objectives. VC firms will typically specialize their
investment with respect to industry, investment stage or geographical regions. The most
significant concentrations of VC firms are in the Silicon Valley California and Boston
The VC fund is formed by the partnership agreement between general and limited
partners. The agreement establishes the expectations of general and limited partners and
outlines the terms of the general partners’ compensation structure. The partnership
agreement also details protections such as accounting and auditing provisions along with
various covenants that restrict the general partners from engaging in certain activities that
might impair limited partners. Limited partners typically include pension plans, life
insurers, foundations and endowments.
Annual investment fees paid by limited partners to general partners tend to be
substantial, ranging from 1% to 3% (2% to 2.5% are norms) of committed capital (as
opposed to portfolio company investment). In addition, agreements normally provide for
20% of carry interest (profits, 20% clawbacks) when the fund liquidates. Obviously, such
high fees to general partners leads to higher required returns from portfolio companies.
General partners normally face restrictive covenants of a variety of types, limiting their
investment in any one firm, various risks, borrowing levels, etc.
In addition to the typical VC firms and their affiliated funds, venture-capital
divisions have been established by a number of large corporations such as Intel and
Motorola. These corporate affiliated divisions typically seek to fund small companies that
have technology or resources that larger firms need. Microsoft, Xerox, Abbott Labs,
Amgen, Merck and many others have also maintained VC units.
Venture capital firms hire experienced principals and devote significant resources
to understanding new technologies and markets to seek promising innovative firms,
provide them funding and provide advice, counsel and management services during their
early stages. The market is aware of the intensity of resources devoted to VC funding,
thus, venture capital funding events are important signals internally and to financial and
other markets about portfolio firm values. Thus, participation by a VC firm enhances firm
value simply because of the signaling value of that participation.
VC firms maintain several mechanisms for monitoring their portfolio firms. First,
venture capitalists bring their networks of contacts and associates including accountants,
lawyers, analysts and executive search firms. VC firms will hold seats on portfolio firm
boards of directors. Hochberg  finds that VC-backed firms filing IPO statements
with the SEC are less likely to engage in aggressive accounting techniques, more likely to
have independent boards and subcommittees and are more likely to separate CEO and
board chair duties. Each of these may be considered to improve the governance of the
portfolio companies and the Venture Capital Association of America claims that VC-
backed firms outperform firms that are not VC-backed.
Bank loans vs. venture capital
Banks make loans and venture capital firms take equity positions. Bank loans and
venture capital placements both tend to have very skewed return distributions, but
differently skewed. Bank loans are skewed left, due to probable fixed payments and less
likely defaults. That is, most bank loans pay face value and limited interest payments and
a smaller percentage default. On the other hand, most venture capital placements are
skewed right, with high probabilities of weak or even negative returns and small
probabilities of extremely high returns. This positive skewness is exacerbated by
convertible securities and combinations of debt and equity.
Differences in the distribution of payoffs affect the monitoring activities of these
providers of capital. Banks engage in much less significant monitoring and control
activity than do VC firms, focusing on restrictive contractual covenants and avoiding or
minimizing bad outcomes. Banks mostly monitor for covenant violations, deteriorating
performance and collateral that impair their loans. They focus more on monitoring to
prevent bad cash flow outcomes. This matches bank incentive structures because banks
do not receive higher payments than those stipulated on bond contracts, thus, they need
not concern themselves with performance beyond the extent to which their loans are
repaid. On the other hand, venture capitalists frequently hold seats on borrowing firms’
boards of directors and often maintain substantial voting rights. They exercise more
control on an ongoing basis. Venture capital firms normally play a more active role in
firm’s major decisions. This more active management role enables them to obtain the
higher payoffs associated with superior performance. While banks tend to focus more on
risk minimization to protect their investment, VC firms accept more risk in an effort to
obtain higher returns. Most bank loans are fully paid while most VC investments result in
B. Development of Modern Venture Capital Markets
Venture funding has existed for many centuries. For example, the funding
provided by Queen Isabella to Christopher Columbus in the late 1400’s might be
regarded to be venture financing. In the late nineteenth century, Thomas Edison sought
$30,000 in R&D funding for the incandescent light bulb, which he hoped would be a less
expensive and safer alternative to the gas lamp. He obtained this financing from a
syndicate of financiers, including J. P. Morgan and the Vanderbilt family. While this
syndicate was not quite what we would now call a venture capital firm, it was typical of
pre-1950s innovative product financing in the U.S.
Feng, Liang and Prowse (1996) and others describe the root of the modern private
equity investment market as dating to the 1946 creation of the American Research and
Development Corporation, a publicly traded closed-end investment company (mutual
fund) to address the need for capital provision to new enterprises and small business. In
addition to capital provision the Corporation sought to provide management services to
portfolio companies. The majority of ARD’s portfolio companies were failures, with one
notable exception – Digital Equipment Company. But, funding many failures along with
an occasional success is typical of the VC process.
A few private venture capital firms were financed by wealthy individuals in the
early to mid 1950s to serve smaller and newer firms, but there were not nearly enough
VC firms to meet the needs of innovative firms. This led to the enactment of IRS Code
1244 which permitted investors of up to $25,000 in qualified small firms to write off
capital losses as expenses. In addition, the Small Business Development Act of 1958 led
development of the Small Business Investment Company (SBIC) operating with the
sanction of the SBA.1 While the SBIC initiative was far more successful in raising and
placing capital with portfolio companies than the American Research and Development
Corporation, manage quality of SBICs tended to be notoriously poor. The modern VC
industry dates to the late 1960s. However, due to changes in capital gains taxes,
economic slowdowns and passage of ERISA, activity in the industry slowed significantly
in the 1970s. It rebounded in the 1980s as these conditions improved, largely owing to a
reduction of the Federal capital gains reduction and the interpretation of the “Prudent
Man Rule” permitting institutions to invest in VC enterprises.
Growth in the VC industry exploded in the 1980s and 90s as the deregulatory
activity, a strengthening economy and participation by pension funds determined that VC
activity could satisfy prudent man rule requirements. Firms funded by the VC industry
during the earlier part of this period included Apple Computer, Genentech, Home Depot,
Minority-Enterprise IBIC's were added by a 1972 amendment to the Act.
Intel, Microsoft and Federal Express; eBay, Jet Blue and Google were successes from the
C. The Venture Capital Process
The overwhelming majority of investment proposals are rejected by VC firms for
a variety of reasons. In fact, only a small portion of proposals are even given more than a
cursory review. Venture capital firms typically seek investment projects in the $250,000
to $4,000,000 outlay range. Projects requiring much more than this range can violate VC
restrictive covenants and those below this range often do produce high enough returns to
scale; their fixed administrative costs are too high. VC firms normally require expected
annual returns in the 30% to 40% range, partly as compensation for the large number of
portfolio company failures. More specifically, VC firms tend to look for the following in
prospective portfolio companies:
1. A solid technology/business concept: The VC firm seeks a unique product,
service or means of production or delivery.
2. A strong management team: The VC firm evaluates the management team for
its ability to innovate, its industry experience, drive, ambition and technical expertise.
Certainly, many prospective portfolio firms will not be able to produce management
teams with all of these attributes. In some cases, the VF can help provide them.
3. Market opportunity: The VC will evaluate the overall size of commercialization
opportunities for the company’s concept along with barriers to market entry along with
other opportunities and threats.
Once a VC commits to finance a firm, it makes a verbal commitment and/or
issues a term sheet outlining the most important aspects of the deal. More detailed
commitment letters may follow and the deal is then closed. The VC will monitor the
investment after the capital is committed. These monitoring activities will usually include
board membership and participation, reviewing portfolio company monthly reports,
performance of financial analysis, etc.
D. Exiting the Investment
A difficult aspect of the venture capital contractual agreement to end the
partnership and repay limited partners within the period specified by the agreement.
Investors participate in VC activities to harvest their investments. VC funds exit their
portfolio company investments through either company or entrepreneur share
repurchases, reorganizations (e.g., ESOPs, MBOs or bankruptcies), private sales,
mergers, IPOs or liquidations (particularly in the event of failure). Private sales, mergers
and IPOs typically provide for the highest valuations, but other exits are very common
since the rates of failure are so high. A private sale or merger enables the VC to recapture
its investment without the expense and publicity associated with the IPO. However, the
IPO certainly enhances the public profile of the portfolio firm.
Benefits and Costs of Going Public
Privately held firms sell stock to the general public for a number of reasons. It is
important for investors in IPOs to discern exactly why a particular firm is being taken
public. These reasons include:
1. To raise capital: A wide distribution of securities to the general public represents
a crucial opportunity for the firm to raise large sums of money for potentially
2. To enable the entrepreneur to “cash out:” Besides enabling the entrepreneur an
opportunity to claim his investment and profits in the offering firm, cashing out
enables the entrepreneur to unload his investment when profit potential is weak.
3. To reduce debt: IPOs enable the firm to raise capital to pay off debt.
4. To enter the market for mergers and acquisitions
5. To affect the distribution of control of the firm: For example, a wide distribution
of stock can dilute the voting power of venture capital firms and other investors,
especially if they use the offering as an opportunity to cash out.
6. To enhance the visibility of the firm: A successful public offering signals strength
and stability of the firm to customers, suppliers, investors and the general public.
A second motivation for increasing the visibility of the firm with an IPO is to
make the firm’s stock more attractive in a secondary offering of shares.
However, these benefits are costly.
1. IPOs generate substantial fees: The offering firm incurs significant legal,
accounting and investment banking fees that frequently exceed 10% of the capital raised
by the offering. We will detail these fees further.
2. Public firms subject themselves to increased disclosure, scrutiny and regulation
by the media, competitors, the general public, the S.E.C. and other regulators. In addition
to potentially drawing unwanted attention, this regulation and accompanying media
coverage may restrict the firm’s operating activities.
3. IPO underpricing: IPO investors enjoy substantial short-term returns on their
investments, presumably at the expense of entrepreneurs.
Direct and Indirect Costs of IPOs
Proceeds Total Average Number of
(in Gross Other Direct Direct & IPOs
Initial Interquartile Range of
millions Spreads Expenses Costs Indirect
Return (in Spread (in %)
of (in %) (in %) (in %) Costs (in
2-9.99 9.05 7.91 16.96 16.36 25.16 337 8.00-10.00
10-19.99 7.24 4.39 11.63 9.65 18.15 389 7.00-7.14
20-39.99 7.01 2.69 9.70 12.48 18.18 533 7.00-7.00
40-59.99 6.96 1.76 8.72 13.65 17.95 215 7.00-7.00
60-79.99 6.74 1.46 8.20 11.31 16.35 79 6.55-7.00
80-99.99 6.47 1.44 7.91 8.91 14.14 51 6.21-6.85
6.03 1.03 7.06 7.16 12.78 106 5.72-6.47
5.67 0.86 6.53 5.70 11.10 47 5.29-5.86
500-up 5.21 0.51 5.72 7.53 10.36 10 5.00-5.37
Totals: 7.31 3.69 11.00 12.05 18.69 1767 7.00-7.05
Direct and Indirect Costs (in %) of Equity IPOs from 1990 to 1994. Taken from Schoar  and based
on: Lee, Lochhead, Ritter, and Zhao (1996)
Feng, George, Nellie Liang and Stephen Prowse (1996), ‘The Economics of the Private
Hochberg Yael (2004). “Venture Capital and Corporate Governance in the Newly Public
Firm.” Unpublished working paper, Cornell University.
Lee, Lochhead, Ritter, and Zhao (1996)
Schoar, A. (2006)