Venture capitalists invest out of a fund, a vehicle that deploys capital on behalf of third-party investors. The investors in these funds, called limited partners, are often pension funds, foundations, corporations, endowments, and wealthy individuals, among others. Given the low liquidity associated with their investment into venture capital funds, limited partners expect large returns—better than those in the stock market—from the funds in which they invest. The funds represent a commitment of capital with a fixed life, typically 10 years. The general partner, a group of partners with fiduciary responsibility for the firm with the legal form of a partnership, manages the capital in the fund. The committed capital is called by the general partner from the limited partners to make a portfolio of investments. Ultimately, when investments mature and become liquid, the profits are shared, with the majority going back to the limited partners and the rest shared by the general partner.
Funding provided by venture capitalists typically takes the form of “rounds,” where a given amount of money is invested into a company at a valuation agreed upon between the management and the investors. Prior to an investment, the equity ownership is divided among the founders, management, and others. The valuation sets a share price against which the venture capital firm buys shares. At each round, the earlier investors and management team strive to increase the valuation for the subsequent round(s) of investment. The higher the valuation of a round, the less dilution (reduction in ownership) the existing shareholders take. While each round contemplates a share price that defines a paper value for an investor’s or an employee’s shares, little actual value is created. Only at a sale event or initial public offering do investors and the management team see a tangible financial return, which can take 5-8 years, if not longer.
Venture capital firms statistically see 100 business plans, take a deep look at 10 of these proposals, and invest in one. This process involves an assessment of the management team, the proposed business, its potential to exclude competition, the market being pursued, and how well the opportunity fits with the firm’s goals.
With an investment, a partner will typically get involved with a company by taking a seat on the board of directors, where he or she works closely with the management team on company strategy and growth. The venture capital industry plays an important role in the economy. Companies supported by early venture capital account for 21 percent of the U.S. gross domestic product by revenue, and 11 percent of private-sector jobs despite the fact that fewer than 1,000 new businesses get venture capital funding any given year (National Venture Capital Association, 2009).
A Brief History of the Venture Capital Industry
Venture capital is said to have originated in 1946 with the founding of the first two firms: American Research and Development Corporation (ARDC) and