Venture capital (VC) is a form of private equity financing provided by firms or funds to startup, early-stage, and emerging companies, that have been deemed to have high growth potential or that have demonstrated high growth in terms of number of employees, annual revenue, scale of operations, etc. Venture capital firms or funds invest in these early-stage companies in exchange for equity, or an ownership stake. Venture capitalists take on the risk of financing start-ups in the hopes that some of the companies they support will become successful. Because startups face high uncertainty, VC investments have high rates of failure. Start-ups are usually based on an innovative technology or business model and often come from high technology industries such as information technology (IT) or biotechnology.
Pre-seed and seed rounds are the initial stages of funding for a startup company, typically occurring early in its development. During a seed round, entrepreneurs seek investment from angel investors, venture capital firms, or other sources to finance the initial operations and development of their business idea. Seed funding is often used to validate the concept, build a prototype, or conduct market research. This initial capital injection is crucial for startups to kickstart their journey and attract further investment in subsequent funding rounds.
Typical venture capital investments occur after an initial "seed funding" round. The first round of institutional venture capital to fund growth is called the Series A round. Venture capitalists provide this financing in the interest of generating a return through an eventual "exit" event, such as the company selling shares to the public for the first time in an initial public offering (IPO), or disposal of shares happening via a merger, via a sale to another entity such as a financial buyer in the private equity secondary market or via a sale to a trading company such as a competitor.
In addition to angel investing, equity crowdfunding and other seed funding options, venture capital is attractive for new companies with limited operating history that are too small to raise capital in the public markets and have not reached the point where they are able to secure a bank loan or complete a debt offering. In exchange for the high risk that venture capitalists assume by investing in smaller and early-stage companies, venture capitalists usually get significant control over company decisions, in addition to a significant portion of the companies' ownership (and consequently value). Privately owned companies who have reached a market valuation of over $1 billion are referred to as unicorns. As of May 2024, there were a reported total of 1248 unicorn companies. Venture capitalists also often provide strategic advice to the company's executives on its business model and marketing strategies.
History Origins of modern venture capital
Before World War II (1939–1945) venture capital was primarily the domain of wealthy individuals and families. J.P. Morgan, the Wallenbergs, the Vanderbilts, the Whitneys, the Rockefellers, and the Warburgs were notable investors in private companies. In 1938, Laurance S. Rockefeller helped finance the creation of both Eastern Air Lines and Douglas Aircraft, and the Rockefeller family had vast holdings in a variety of companies. Eric M. Warburg founded E.M. Warburg & Co. in 1938, which would ultimately become Warburg Pincus, with investments in both leveraged buyouts and venture capital. The Wallenberg family started Investor AB in 1916 in Sweden and were early investors in several Swedish companies such as ABB, Atlas Copco, and Ericsson in the first half of the 20th century.
Only after 1945 did modern venture capital investment firms begin to emerge, notably with the founding of American Research and Development Corporation (ARDC) and J.H. Whitney & Company in 1946.Wilson, John. The New Venturers, Inside the High Stakes World of Venture Capital.
Georges Doriot, the "father of venture capitalism", along with Ralph Flanders and Karl Compton (former president of MIT) founded ARDC in 1946 to encourage private-sector investment in businesses run by soldiers returning from World War II. ARDC became the first institutional private-equity investment firm to raise capital from sources other than wealthy families. Unlike most present-day venture capital firms, ARDC was a publicly traded company. ARDC's most successful investment was its 1957 funding of Digital Equipment Corporation (DEC), which would later be valued at more than $355 million after its initial public offering in 1968. This represented a return of over 1200 times its investment and an annualized rate of return of 101% to ARDC.Ante, Spencer E.. Creative capital: Georges Doriot and the birth of venture capital. Boston, Harvard Business Press, 2008.
Former employees of ARDC went on to establish several prominent venture capital firms including Greylock Partners, founded in 1965 by Charlie Waite and Bill Elfers; Morgan, Holland Ventures, the predecessor of Flagship Ventures, founded in 1982 by James Morgan; Fidelity Ventures, now Volition Capital, founded in 1969 by Henry Hoagland; and Charles River Ventures, founded in 1970 by Richard Burnes.Kirsner, Scott. "Venture capital's grandfather." The Boston Globe, April 6, 2008. ARDC continued investing until 1971, when Doriot retired. In 1972 Doriot merged ARDC with Textron after having invested in over 150 companies.
Early venture capital and the beginning of Silicon Valley
One of the first steps toward a professionally managed venture capital industry was the passage of the Small Business Investment Act of 1958. The 1958 Act officially allowed the U.S. Small Business Administration (SBA) to license private "Small Business Investment Companies" (SBICs) to help the financing and management of the small entrepreneurial businesses in the United States. Small Business Administration Investment Division (SBIC) The Small Business Investment Act of 1958 provided tax breaks that helped contribute to the rise of private-equity firms.
During the 1950s, putting a venture capital deal together may have required the help of two or three other organizations to complete the transaction. It was a business that was growing very rapidly, and as the business grew, the transactions grew exponentially.Lea, Charles. "Tape 4- Charles Lea". Interview by Charles Rudnick. National Venture Capital Association Venture Capital Oral History Project Funded by Charles W. Newhall III. September 18, 2008. Arthur Rock, one of the pioneers of Silicon Valley during his venturing the Fairchild Semiconductor is often credited with the introduction of the term "venture capitalist" that has since become widely accepted.
During the 1960s and 1970s, venture capital firms concentrated their investments mainly on launching and growing companies. These companies frequently capitalized on breakthroughs in electronic, medical, or data-processing technologies. As a result, venture capital came to be almost synonymous with financing of technology ventures. An early West Coast venture capital company was Draper and Johnson Investment Company, formed in 1962 by William Henry Draper III and Franklin P. Johnson Jr. In 1965, Sutter Hill Ventures acquired the portfolio of Draper and Johnson as a founding action. Bill Draper and Paul Wythes were the founders, and Pitch Johnson formed Asset Management Company at that time.
It was also in the 1960s that the common form of private-equity fund, still in use today, emerged. Private-equity firms organized limited partnerships to hold investments in which the investment professionals served as general partner and the investors, who were passive limited partners, put up the capital. The compensation structure, still in use today, also emerged with limited partners paying an annual management fee of 1.0–2.5% and a carried interest typically representing up to 20% of the profits of the partnership.
In the 1970s, the US Government made two significant changes fuelling growth of Venture Capital firms:
ERISA (Employee Retirement Income Security Act), 1972 & 1979 Capital Gains tax reduction from 48.5% to 20%.
The growth of the venture capital industry was fueled by the emergence of the independent investment firms on Sand Hill Road, beginning with Kleiner Perkins and Sequoia Capital in 1972. Located in Menlo Park, California, Kleiner Perkins, Sequoia and later venture capital firms would have access to the many semiconductor companies based in the Santa Clara Valley as well as early computer firms using their devices and programming and service companies. Kleiner Perkins was the first venture capital firm to open an office on Sand Hill Road in 1972.
Throughout the 1970s, a group of private-equity firms, focused primarily on venture capital investments, would be founded that would become the model for later leveraged buyout and venture capital investment firms. In 1973, with the number of new venture capital firms increasing, leading venture capitalists formed the National Venture Capital Association (NVCA). The NVCA was to serve as the industry trade group for the venture capital industry. Official website of the National Venture Capital Association, the largest trade association for the venture capital industry. Venture capital firms suffered a temporary downturn in 1974, when the stock market crashed and investors were naturally wary of this new kind of investment fund.
It was not until 1978 that venture capital experienced its first major fundraising year, as the industry raised approximately $750 million. With the passage of the Employee Retirement Income Security Act (ERISA) in 1974, corporate pension funds were prohibited from holding certain risky investments including many investments in privately held companies. In 1978, the US Labor Department relaxed certain restrictions of the ERISA, under the "prudent man rule", thus allowing corporate pension funds to invest in the asset class and providing a major source of capital available to venture capitalists.
1980s and VC involvement in large American companies The public successes of the venture capital industry in the 1970s and early 1980s (e.g., Digital Equipment Corporation, Apple Inc., Genentech) gave rise to a major proliferation of venture capital investment firms. From just a few dozen firms at the start of the decade, there were over 650 firms by the end of the 1980s, each searching for the next major "home run". The number of firms multiplied, and the capital managed by these firms increased from $3 billion to $31 billion over the course of the decade.POLLACK, ANDREW. "Venture Capital Loses Its Vigor ." New York Times, October 8, 1989.
The growth of the industry was hampered by sharply declining returns, and certain venture firms began posting losses for the first time. In addition to the increased competition among firms, several other factors affected returns. The market for initial public offerings cooled in the mid-1980s before collapsing after the stock market crash in 1987, and foreign corporations, particularly from Japan and Korea, flooded early-stage companies with capital.
In response to the changing conditions, corporations that had sponsored in-house venture investment arms, including General Electric and Paine Webber either sold off or closed these venture capital units. Additionally, venture capital units within Chemical Bank and Continental Illinois National Bank, among others, began shifting their focus from funding early stage companies toward investments in more mature companies. Even industry founders J.H. Whitney & Company and Warburg Pincus began to transition toward leveraged buyouts and growth capital investments.Kurtzman, Joel. " PROSPECTS; Venture Capital." New York Times, March 27, 1988.LUECK, THOMAS J. " High Tech's Glamour fades for some venture capitalists." New York Times, February 6, 1987.