Where venture money plays an important role is in the next stage of the innovation life cycle—the

period in a company’s life when it begins to commercialize its innovation. We estimate that more
than 80% of the money invested by venture capitalists goes into building the infrastructure
required to grow the business—in expense investments (manufacturing, marketing, and sales) and
the balance sheet (providing fixed assets and working capital).

Venture money is not long-term money. The idea is to invest in a company’s balance sheet and
infrastructure until it reaches a sufficient size and credibility so that it can be sold to a corporation
or so that the institutional public-equity markets can step in and provide liquidity. In essence, the
venture capitalist buys a stake in an entrepreneur’s idea, nurtures it for a short period of time, and
then exits with the help of an investment banker.

Venture capital’s niche exists because of the structure and rules of capital markets.
Someone with an idea or a new technology often has no other institution to turn
to. Usury laws limit the interest banks can charge on loans—and the risks inherent
in start-ups usually justify higher rates than allowed by law. Thus bankers will
only finance a new business to the extent that there are hard assets against which
to secure the debt. And in today’s information-based economy, many start-ups
have few hard assets.
Venture capital fills the void between sources of funds for innovation (chiefly
corporations, government bodies, and the entrepreneur’s friends and family) and
traditional, lower-cost sources of capital available to ongoing concerns. Filling
that void successfully requires the venture capital industry to provide a sufficient
return on capital to attract private equity funds, attractive returns for its own
participants, and sufficient upside potential to entrepreneurs to attract high-quality
ideas that will generate high returns. Put simply, the challenge is to earn a
consistently superior return on investments in inherently risky business ventures.
Investors in venture capital funds are typically very large institutions such as
pension funds, financial firms, insurance companies, and university endowments
—all of which put a small percentage of their total funds into high-risk
investments. They expect a return of between 25% and 35% per year over the
lifetime of the investment. Because these investments represent such a tiny part of
the institutional investors’ portfolios, venture capitalists have a lot of latitude.
What leads these institutions to invest in a fund is not the specific investments but
the firm’s overall track record, the fund’s “story,” and their confidence in the
partners themselves.
One myth is that venture capitalists invest in good people and good ideas. The
reality is that they invest in good industries—that is, industries that are more
competitively forgiving than the market as a whole. In 1980, for example, nearly
20% of venture capital investments went to the energy industry. More recently,
the flow of capital has shifted rapidly from genetic engineering, specialty retailing,
and computer hardware to CD-ROMs, multimedia, telecommunications, and
software companies. Now, more than 25% of disbursements are devoted to the
Internet “space.” The apparent randomness of these shifts among technologies and
industry segments is misleading; the targeted segment in each case was growing
fast, and its capacity promised to be constrained in the next five years.
In effect, venture capitalists focus on the middle part of the classic industry S-
curve. They avoid both the early stages, when technologies are uncertain and
market needs are unknown, and the later stages, when competitive shakeouts and
consolidations are inevitable and growth rates slow dramatically
Thus the critical challenge for the venture capitalist is to identify competent
management that can execute—that is, supply the growing demand.

There are many variants of the basic deal structure, but whatever the specifics, the logic of the deal
is always the same: to give investors in the venture capital fund both ample downside protection
and a favorable position for additional investment if the company proves to be a winner.

In a typical start-up deal, for example, the venture capital fund will invest $3 million in exchange
for a 40% preferred-equity ownership position, although recent valuations have been much higher.
The preferred provisions offer downside protection. For instance, the venture capitalists receive a
liquidation preference. A liquidation feature simulates debt by giving 100% preference over
common shares held by management until the VC’s $3 million is returned. In other words, should
the venture fail, they are given first claim to all the company’s assets and technology. In addition,
the deal often includes blocking rights or disproportional voting rights over key decisions,
including the sale of the company or the timing of an IPO.
VC firms also protect themselves from risk by coinvesting with other firms.
Typically, there will be a “lead” investor and several “followers.” It is the
exception, not the rule, for one VC to finance an individual company entirely.
Rather, venture firms prefer to have two or three groups involved in most stages of
financing. Such relationships provide further portfolio diversification—that is, the
ability to invest in more deals per dollar of invested capital. They also decrease the
workload of the VC partners by getting others involved in assessing the risks
during the due diligence period and in managing the deal. And the presence of
several VC firms adds credibility. In fact, some observers have suggested that the
truly smart fund will always be a follower of the top-tier firms.
In return for financing one to two years of a company’s start-up, venture
capitalists expect a ten times return of capital over five years. Combined with the
preferred position, this is very high-cost capital: a loan with a 58% annual
compound interest rate that cannot be prepaid. But that rate is necessary to deliver
average fund returns above 20%. Funds are structured to guarantee partners a
comfortable income while they work to generate those returns. The venture capital
partners agree to return all of the investors’ capital before sharing in the upside.
However, the fund typically pays for the investors’ annual operating budget—
2% to 3% of the pool’s total capital—which they take as a management fee
regardless of the fund’s results. If there is a $100 million pool and four or five
partners, for example, the partners are essentially assured salaries of $200,000
to $400,000 plus operating expenses for seven to ten years. (If the fund fails, of
course, the group will be unable to raise funds in the future.)
On average, good plans, people, and businesses succeed only one in ten times. To
see why, consider that there are many components critical to a company’s success.
The best companies might have an 80% probability of succeeding at each of them.
But even with these odds, the probability of eventual success will be less than
20% because failing to execute on any one component can torpedo the entire
company.

A typical breakout of portfolio performance per $1,000 invested is shown below:

Those probabilities also have a great impact on how the venture capitalists spend their time. Little
time is required (and sometimes best not spent) on the real winners—or the worst performers,
called numnuts (“no money, no time”). Instead, the VC allocates a significant amount of time to
those middle portfolio companies, determining whether and how the investment can be turned
around and whether continued participation is advisable. The equity ownership and the deal
structure described earlier give the VCs the flexibility to make management changes, particularly
for those companies whose performance has been mediocre.