The American economy is driven by invention and innovation. Additionally, they have a strong hold on the collective imagination of the country. The mainstream media is overflowing with tales of Silicon Valley entrepreneurs succeeding against all odds. The modern-day cowboy, the entrepreneur in these tales, is venturing out into uncharted industrial territory in a manner reminiscent of the early Americans’ exploration of the West. The venture capitalist, a shrewd sidekick who is willing to aid the hero through all the difficult moments in exchange for a cut of the action, is by his side.
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Like most myths, this one has some element of reality. The roles that Arthur Rock, Tommy Davis, Tom Perkins, Eugene Kleiner, and other pioneering venture investors played in establishing the contemporary computer industry are legendary. Their operational expertise and investment know-how were just as significant as their funds. However, over the past 30 years, the venture capital industry has changed, making the stereotype of a cowboy with a sidekick less and less relevant. The entrepreneurs that venture capitalists support today resemble MBAs more than bankers.
The global venture capital business is admired for its ability to stimulate economic expansion and growth. Even if the industry is romanticized in the public mind, it is essential to distinguish between popular myths and contemporary reality in order to comprehend the functioning of this significant sector of the American economy. A study of this kind might be very helpful for business owners and would-be owners.
Venture Funding Closes a Gap
Despite what the general public believes, venture capital is not a major factor in supporting basic innovation. In 1997, venture capitalists put in over $10 billion, yet just $600 million, or 6% of the total, went to start-ups. Furthermore, we calculate that R&D accounted for less than $1 billion of the venture capital pool as a whole. Most of that money was used to continue supporting initiatives that were started with far larger investments from firms ($133 billion) and governments ($63 billion).
The following phase of the innovation life cycle, when a business starts to market its invention, is where venture capital comes into play. According to our estimates, over 80% of venture capitalists’ investments are used to construct the infrastructure needed for the company to expand, with the majority going toward balance sheet items like fixed assets and working capital as well as expense investments in manufacturing, marketing, and sales.
Investment money for ventures is not long-term. Investing in a firm’s infrastructure and balance sheet is the objective here, either until the company grows to a size and reputation that allows it to be sold to a corporation or until institutional public stock markets can step in and offer liquidity. To put it simply, a venture capitalist purchases an initial investment in an entrepreneur’s concept, supports it for a little while, and then, with the assistance of an investment banker, walks away.
The structure and regulations of capital markets are what allow venture capital to have its specialty. There is frequently no alternative institution for someone with an idea or new technology to turn to. Bank interest rates are restricted by usury regulations, and the risks associated with starting a business typically warrant higher interest rates than those permitted by law. Consequently, lenders will only provide funding for a startup company if there are tangible assets available to secure the loan. Furthermore, many start-ups in the information-based economy of today have little tangible assets.
Furthermore, rules and procedures designed to safeguard public investors impose restrictions on both investment banks and public equity. In the past, a business needed assets of $10 million, revenues of around $15 million, and a consistent track record of profitability in order to be admitted to the public market. In context, the United States has over 5 million firms, of which less than 2% generate annual revenues of more than $10 million. Even though development-stage firm stocks were recently issued, lowering the IPO requirement, the funding window for businesses with less than $10 million in sales is still generally closed to entrepreneurs.
Enough Profits at a Manageable Risk
Large organizations including pension funds, insurance companies, financial corporations, and university endowments are common investors in venture capital funds; each of these groups allocates a tiny portion of their overall assets to high-risk ventures. Throughout the course of the investment, they anticipate a return of between 25% and 35% annually. Venture capitalists have a great deal of flexibility because these investments make up such a small portion of the portfolios of institutional investors. These institutions are more likely to invest in a fund based on the firm’s overall performance history, the fund’s “story,” and their faith in the partners than on the particular investments.