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Venture Capital - The Funding of Ideas

Industry Overview

VC firms raise money from corporations, financial institutions, private foundations, university endowments, and wealthy individuals. The money-sometimes as much as several hundred million dollars-goes into funds, which are invested in start-ups in return for a share of ownership. When the start-up goes public or gets acquired, the investment is cashed in for huge profits. Typically, the VC firm distributes 75 to 80 percent of the return to the original investors and keeps 20 to 25 percent for itself. Sometimes the start-up goes nowhere and the investors lose money.

VC funding has nourished some of corporate America's greatest success stories when they were still baby businesses-FedEx, Intel, Sun Microsystems, and Apple, to name a few. Once a VC firm has sorted through stacks of business plans and selected a few lucky companies to invest in, the firm's partners usually help those firms by arranging services, introducing contacts, setting up strategic partnerships, and often taking seats on their boards of directors. The VC firm usually hopes for an exit event-an IPO or acquisition that will let the VC firm cash out-in about five years from the time it invests.

In the midst of a slowing economy, the VC industry is undergoing tremendous change. In the late 1990s, venture capitalists focused primarily on high-tech companies to meet their lofty return-on-capital goals, investing an astronomical $104.2 billion in start-ups alone, according to the National Venture Capital Association. But with online retailers closing up shop and Internet IPOs more rare than steak tartare, many VC funds are turning their full attention to areas such as biotech. With tight funding and a slew of failing Internet companies in their portfolios, venture capital firms are exercising much more caution, investing warily and with less money.

Down-Rounding the Dot Coms
As the NASDAQ suffers, VC firms have a lot of cleaning up to do. Most poured millions into Internet start-ups in 1999 and 2000, and as these companies flounder or fold, venture capitalists face some tough choices. Many of the 200 or so Internet-driven VC firms launched in the past few years have gone bankrupt. And more-resilient VC funds are shutting down their failing start-ups by pulling out of the next round of funding needed to keep them afloat, or holding back funds until the venture shows survival signs. A couple of years ago, start-ups could pick and choose their favorite VCs; now firms are consolidating their portfolios and doling out "down rounds," much lower valuations of funding, to surviving ventures fighting for investor support.

Industry Shake-Out in Progress
Venture investments dropped 65 percent between 2000 and 2001 as the stock market downturn slammed the lucrative IPO window shut and slashed the valuations of both public and private companies. In Q4 2000, VCs saw the first negative quarterly return for the industry (-6.3 percent) since 1998.

Things have not gotten better. The 341 mergers and acquisitions of VC-backed companies in 2001 were 23 percent fewer than in 2000, worth $19.8 billion compared to $101.1 billion. VC fundraising dropped from $90.1 billion in 2000 to $48.2 billion in 2001. Investments in the industry's biggest sectors, including software, networking, biotech, and telecommunications, all declined. Star VC John Doerr from Kleiner Perkins even apologized for once calling the Internet "the largest legal creation of wealth in the history of the planet." All this made 2001 the worst year on record, with VC funds falling 27.8 percent, the worst one-year decline since the National Venture Capital Association (NVCA) started tracking the data in 1969.

According to Venture Economics (VE) and the NVCA, a rebound is still several years away. "There is too much money in VC," says an insider. "What we're doing now is waiting for the time our industry recovers, and that will be measured in years, not quarters."

There are many kinds of players in the VC world, from traditional VC firms to funds operated by publicly owned corporations. Some are tightly focused-by stage of investment, region, or type of industry-but most have a much broader focus. Here's a rough breakdown of the industry:

Private VC Firms (Early- to Mid-Stage)
Firms in this segment follow the classic VC model: Find an entrepreneur with a great idea and business plan, sprinkle with cash, bake for several years, and sell for a hefty chunk of change. Early-stage (or seed) investments are the riskiest, since many start-ups tank. Still, they often provide the highest returns since investors coming in early can pay a lower price for a given share of equity. In the 1990s, as many traditional VC firms started to focus on middle- and late-stage investments, seed financing increasingly became the province of newer firms and angel investors-entrepreneurs or corporate executives who've made it big and have money to spend.

Private VC Firms (Mid- to Late Stage)
These firms, many of which also operate at the seed level, provide funds to companies that are already established-those that have a product, sufficient employees, and perhaps even revenues. At these stages, firms inject more capital into the company to help it become profitable so that it will attract enough interest to either be acquired by a larger company or go public.

Growth Buyout Funds
Some VCs have moved into growth buyouts of larger private companies or divisions of public companies. These funds invest larger amounts of capital-up to $100 million-in exchange for a significant minority or majority position in the company. By focusing on stable, growing (and often profitable) companies, buyout funds don't have to wait long before they can cash in on the company's IPO or sale. There's less risk-unless market factors cause the delay of an IPO, for example. The funded company and its earlier investors benefit from having a prestigious late-stage investor add credibility on Wall Street come IPO time.

Financial-Services Firms
Where there's money, of course you'll find I-bankers. Banks such as Morgan Stanley and Citicorp will invest in the later stages. The aim is pretty much the same as that of the VCs: to make a killing through either an IPO or an acquisition.

Corporate Funds
As opposed to private funds, whose primary goal is monetary gain, corporate funds have the added goal of strategically investing in companies whose business relates in some way to the corporation's own. For example, Microsoft invested in Qwest Communications, a telecom company that is building a fiber-optic network, to help it deliver NT-based software.

Finding a job in VC isn't hopeless, but it will be hard. Firms are selective, and finding a job requires good luck. "The way to gain access to this industry is to do something great that is visible to people in this industry," says an insider. "There's not a lot on your resume that will tell whether you will do well in venture capital."

The venture capital industry is small and hires only a select few each year. Traditionally dominated by seasoned executives, many firms consist only of general partners and administrative staff, though some larger firms also have associates and analysts. However, even large firms may have only one associate for every three partners. In the active market of recent years, VC firms increased hiring at junior levels; but there is far less new investment activity now, resulting in fewer employment opportunities.

Venture capital firms' hiring needs, unlike those of investment banks or consulting firms, are so specialized and limited that VC firms don't really have to do much recruiting. When they are looking to hire, they often keep it quiet so they won't be bombarded with resumes. A few of the larger firms may show up at a specific campus (Stanford, Harvard) and do some interviews; but generally, VC firms will approach people with the specific skill sets they want, based on referrals from sources that they trust. Remember that in many ways the venture capital business is all about networking, and this applies to the firms' hiring procedures as their business methods.

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