The sad state of the venture capital industry

feature-sad-vc-200Venture Capital (VC) is often viewed by the mainstream media as an exciting and glamorous part of the entrepreneurial landscape.

The popular image portrayed is that of Dragon’s Den, where hopeful would-be entrepreneurs pitch their ideas to a panel of wealthy investors in a reality TV show. Within the university sector the teaching of entrepreneurship is often focused on getting students to develop business plans and pitch to prospective venture financiers using the Dragon’s Den as a role model.

There is no doubt that VC funding has an important place in the wider landscape of business financing. It is also a good idea for would-be entrepreneurs to learn how to prepare and present business plans. However, the reality is that VC funds only a tiny percentage of businesses. In fact, research by the Kauffman Foundation suggests that less than 1% of the estimated 600,000 new employer businesses created in the United States each year obtain VC financing.

Most new start-up ventures are funded by the founder’s savings, credit cards and what they can borrow from the “Three F’s”. These are the family, friends and fools who usually invest in early stage ventures more out of a desire to support the entrepreneur than any rational investment decision. Banks also provide a good deal of money to new ventures, but typically as a second mortgage secured against the entrepreneur’s home or personal assets. VC funding is rare and securing it is nothing like a reality TV show.

What is the venture capital industry?

The VC industry (if we can even use this term) is relatively young. Equity financing of fast-growing ventures has been around for a long time. There have been merchant banks since the middle ages and investment banking has been around since the 1930s. Private investment in the form of “business angels” has also been a feature of the entrepreneurial landscape since the 1920s. It emerged when Broadway musicals were funded by wealthy uptown patrons of the theatre who would come downtown like angels to provide the cash needed by producers to bankroll new shows. However, the VC industry as it is known today emerged in the 1990s.

The VC industry is difficult to define. It typically involves formal and informal levels of investment by different institutions across the emerging life-cycle of the business. As shown in the following diagram, the venture capital cycle moves through a series of stages. It commences with informal investing by family, friends and sometimes business angels. If the business needs more money it will proceed through a series of stages until it might go to the open market via an initial public offering (IPO).

This is broadly the funding cycle followed recently by Facebook. It is understood that a major motivator for the Facebook listing was the desire by VC investors to get their money back out. In 2011, Facebook had a valuation of over US$100 billion although its revenue for 2010 was only $2 billion. The list of shareholders who took the company to market is a who’s who of American angel investors and corporate VC funds. A key part of the VC strategy is to exit the deal, so these investors were keen to see the IPO as a means of opening the escape hatch.

The boom and bust of the VC industry

Much of the current hype about VC investing emerged in the United States during the 1990s. The technological changes, particularly in the field of information and communications technologies (ICT) that emerged from the 1970s and 1980s provided opportunities for new enterprises. Companies like Apple, Google, Microsoft, Starbucks, Cisco and Genentech were all recipients of VC funding during their growth cycles.

ICT investments and some opportunities in biotechnology and medical or health science were key fields for VC investment. According to the US National Venture Capital Association (the VC industry lobby group) from 1970 to 2005 VC funding created around 10 million new jobs and US$2.1 trillion in revenues within the United States. By 2007, VC investment in the USA was estimated at around US$29.4 billion across some 3,813 deals. Approximately half of this money was invested evenly across biotechnology, medical technology and ICT areas. The dotcom boom of 1999-2000 was a peak in the VC investment process and something of a high water mark for the sector.

Despite the initially impressive growth of the VC industry during the 1990s, the performance of VC investments over the past decade has been unimpressive. Research undertaken by the Kauffmann Foundation suggests that only 20 out of 100 venture funds produced returns that were better than the public sharemarket by more than 3% per annum. Of these the majority were invested prior to 1995.

Of the majority of US VC funds, 62% failed to exceed returns otherwise available from the public stock markets, particularly after management fees and associated costs were factored in. There is also no consistent evidence of a “J” curve emerging in VC investments since at least 1997 and only 13% of VC funds with over US$400 million of capital invested produced better returns than could be obtained on the stock market. Overall, the majority (78%) of VC funds examined failed to deliver sufficient returns to reward patient long-term investors.

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