What Is Venture Capital?
The composer of the term "venture capital"
is unknown, and there is no standard definition of it.
It is generally agreed that the traditional venture-capital
era began in earnest in 1946, when General Georges Doriot,
Ralph Flanders, Karl Compton, Merrill Griswold and others
organized American Research & Development (AR&D),
the first (and, after it went public, for many years the
only) public corporation specializing in investing in
illiquid securities of early stage issuers.
One way to define traditional "venture capital"
is to repeat General Doriot's rules of investing, the
thought being that an investment process entailing Doriot's
rules is, by definition, a venture-capital process. According
to Doriot, investments considered by AR&D involved:
- new technology, new marketing concepts, and new product
application possibilities;
- a significant but not necessarily controlling participation
by the investors in the company's management;
- investment in ventures staffed by people of outstanding
competence and integrity;
- products or processes which have passed through at
least the early prototype stage and are adequately protected
by patents, copyrights, or trade-secret agreements (the
latter rule is often referred to as investing in situations
where the information is "proprietary");
- situations which show promise to mature within a
few years to the point of an initial public offering
or a sale of the entire company (commonly known as the
"exit strategy");
- opportunities in which the venture capitalist can
make a contribution beyond the capital dollars invested
(often referred to as the "value-added strategy").
General Doriot's boundary conditions are to be treated
with great deference because it is commonly agreed that
Doriot is the single most significant figure in postwar
traditional venture capital. Not only did he provide AR&D
with its primary guidance (until it was acquired by Textron),
but he also introduced a significant percentage of today's
senior venture capitalists to the business through the
courses he taught at Harvard Business School. And he showed
the world how a traditional venture-capital investment
strategy could produce enormous rewards when AR&D's
modest investment in Digital Equipment Corporation (DEC)
ballooned into investor values in the billions.
In the eyes of the public of his day, Doriot's record
at AR&D included only a few "home runs"—DEC
in particular—and a bunch of losers, leading inexperienced
observers to conclude that a well-managed venture portfolio
should concentrate on the long ball—the one investment
that will return two or three hundred times one's money
and justify a drab performance by the rest of the portfolio.
This fallacious conclusion fostered the 1960s notion that
an ultra-high-risk strategy is characteristic of venture-capital
investing. In fact, the AR&D strategy was never tied
to the solo home run. Moreover, venture strategies have
become highly varied. Some venture pools focus in whole
or in part on late-round investments: infusions of cash
shortly before the company is planning to go public, for
example. Moreover, as outlined subsequently, buyouts involving
mature firms are a popular venture strategy, as are so-called
turnarounds, investments in troubled companies, including
some actually in bankruptcy. And some funds are hybrids,
sharing more than one strategy, even including a portion
of the assets invested in public securities. The point
is that a venture manager balances risk against reward;
a "pre-seed" investment should forecast sensational
returns, while a late-round purchase of convertible debt
will promise a more modest payoff.
The term "venture capital" is grammatically
multifaceted. General Doriot's exegesis specifies a certain
type of investment as characteristic of the venture universe.
He assumes, a priori, the proposition that venture capital
involves a process, the making and managing (and ultimately
selling) of investments. In addition, the phrase is sometimes
used as an adjective applied to players in the game; that
is, "venture-backed companies," meaning the
portfolio opportunities in which the venture-capital partnerships
or "funds" invest. The phrase becomes a noun
when it describes the capital provided by individuals,
families, and firms, which entities, along with the partnership
managers, are called venture capitalists.
In terms of the people involved, venture capital is an
intense business. The symbiotic relationship between the
venture capitalist and his investment (assuming he is
the "lead investor," meaning the investor most
closely identified with the opportunity) is such that
each professional can carry a portfolio of no more than
a handful of companies. The investors are usually experienced
professionals with formal academic training in business
and finance and on-the-job training as apprentices at
a venture fund or financial institution. Their universe
is still relatively small; they and their advisers tend
to be on a first-name basis, veterans of a deal or two
together. And the work is hard, particularly since on-site
visits impose an enormous travel burden.
The venture-capital process, before it was so labeled,
has existed for centuries; antedating American Research
& Development, it is as old as commercial society
itself. In this century, for example, Vanderbilt interests
financed Juan Trippe in the organization of Pan American
Airways, Henry Ford was financed by Alexander Malcolmson,
and Captain Eddie Rickenbacker was able to organize Eastern
Airlines in the 1930s with backing from the Rockefellers.
However, the era of professionally managed venture capital—pools
of money contributed by unrelated investors and organized
into separate legal entities, managed by experts according
to stated objectives, set forth in a contract between
managers and investors, describing a structured activity,
an activity that conforms to definite patterns and rules—is
a process that dates from the organization of AR&D.
The term venture capital can be applied to investments,
people, or activities. With full appreciation for the
multiple uses of the term, the thrust and emphasis of
this article (although not exclusively) is on venture
capital of the type which is compatible with the Doriot
rules. First, venture capital is an activity involving
the investment of funds. It ordinarily involves investments
in illiquid securities, which carry higher degrees of
risk (and commensurately higher possibilities of reward)
than so-called traditional investments in the publicly
traded securities of mature firms. The venture-capital
investor ordinarily expects that his participation in
the investment (or the participation of one of the investors
in the group which he has joined, designated usually as
the "lead investor") will add value, meaning
that the investors will be able to provide advice and
counsel designed to improve the chances of the investment's
ultimate success. The investment is made with an extended
time horizon, required by the fact that the securities
are illiquid. (In this connection, most independent venture
funds are partnerships scheduled to liquidate ten to twelve
years from inception, in turn suggesting that a venture-capital
investment is expected to become liquid somewhere around
four to six years from initial investment.)
Since the most celebrated rewards in the past have generally
accrued to investments involving advances in science and
technology to exploit new markets, traditional venture-capital
investment is often thought of as synonymous with high-tech
start-ups. However, that is not an accurate outer boundary,
even in the start-up phase. For example, the technology
of one of the great venture-capital winners—Federal
Express—is as old as the Pony Express, and it would
take a great stretch of the imagination to perceive of
fast-food chains such as McDonald's as involving additions
to our store of scientific learning. But, whether high
or low tech, the traditional venture capitalist thrives
when the companies in which he invests have an advantage
over potential competition in a defined segment of the
market, often referred to as a "niche." The
product or service is as differentiated as possible. Exploitation
of scientific and technological breakdowns has, historically,
been a principal way (but not the only way) for emerging
companies to differentiate themselves from their more
mature and better-financed competitors.
By VC Experts, Inc.
