What You Need to Know about Venture Capital

In: Insights

Venture capital (“VC”) may be the most misunderstood phenomena in global finance today. Media like “Dragon’s Den”, or the American version “Shark Tank”, present it as the means for entrepreneurs to transform a simple good idea to the next Uber or other billion-dollar multinational.

But how can venture capital help your business to become a globally recognised brand? It certainly has the form to do so.

Venture Capital – an American Phenomenon to Advance Technology

Frederick Terman – Brought the idea of VC to the west coast and is accredited as helping to make Silicon Valley what it is today

Venture capital first took shape as a financing method for new and growing businesses in America. The Economist succinctly traces those roots with this article subtitle: “The modern world is built on two centuries of industrialisation. Much of that was built by equity finance. Which is built on limited liability.” New York passed the first limited liability laws in 1811 – making it so investors in a business were not personally liable if a company failed.

That law alone took the risk out of providing equity and taking shares in business endeavors. Britain followed in 1854.

Limited liability paved the road, but venture capital itself did not take shape until after World War II. The first equity financers were interested in utilities and other proven industries that had real value – they did not seek risks but were interested in shares of profitable companies.

Then World War II happened. The United States was interested in technological development to stay ahead of the Allies, but a viable investment system to pay for technological ideas (as opposed to proven business strategies like railroads, department stores, and utilities) did not exist. Banks were hesitant to lend to ideas that lacked proof of income, and equity financers were hesitant to lend to ideas that lacked proof of concept.

The US government gave tremendous grants to university research teams with only ideas to develop a wide array of technologies to advance military warfare, both during and after the war. Obviously, the investments paid off, with some of the most incredible breakthroughs in the modern era derived from that funding (the Atomic bomb and modern fertilizers being just two).

The first venture capital firm came shortly after. Georges Doriot’s American Research and Development Corporation was a public company aimed at attracting institutional investors in private equity. Their first famous deal was a $70,000 equity investment in the Digital Equipment Corporation in 1957 that turned around a large gain when the company went public in 1966.

Frederick Terman, a Stanford University professor that had been part of government-funded research teams during the war, brought the idea of VC to the west coast. His advancement of Stanford as a research powerhouse for tech made Silicon Valley what it has evolved into today. The US took it to another level however, by making VC mainstream and public with a series of national laws and government programs to fund investments.

VC made Apple; it made the computer. And then the internet came about in the early 1990s and with it the VC boom.

Venture Capital – Trending Globally

Though it has historically been an American phenomenon, venture capital is moving quickly overseas to growing tech markets. Ernst and Young reported in 2015 that, from 2006 to 2013, the US took $254.6 billion of all $373 billion invested globally via VC. In 2014 alone, US companies took $52.1 billion of $86.7 billion in total investments – it’s share fell from 70 to 60 percent in just one year. More and more money is going to China, India, and the EU – only around 50 percent will stay in the US in 2017.

That does not mean that the US is taking in less equity – it just means that VC equity is growing globally, and in new markets.

According to the World Economic Forum, venture capitalists invested $13.6 billion in the EU’s tech sector in 2016, compared to $2.8 billion in 2011. The EU now boasts 4.7 million professional developers to the United States’ 4.1 million, as greater investment from government and private sector channels has boosted talent in high tech fields and is now attracting more and more private equity.

In fact, the EU venture capital industry is reaching “a turning point” according to Invest Europe experts. Even though the EU has a similar size economy compared to the United States, it has only around one fifth of the movement in VC as its counterpart. IE’s data shows that over the past 5 years, North American investors have contributed 10 percent of the capital invested in EU VC funds, which is double the average for the previous five years.

That statistic is significant combined with the fact that VC spending in the States is on track to be the highest in 2017 than since the turn of the century – with more than $61.4 billion in deals turned through quarter three alone.

EU growth is still slow compared to Asia, however. Both China and India’s share of VC capital as a portion of the global whole doubled from 2006 to 2014, according to Ernst and Young. And the global “rest” have started taking a share. VC4A.com, an African venture capital sharing platform, boasts 8,500 startups and millions of dollars invested, to fund new tech and advance startups across the continent.

The Future of Venture Capital: Global Trends

10 most valuable companies that used Venture Capital at startup

Beyond geographical distribution, VC is seeing a transformation in its fundamental role. While billions will continue to go into technological developments, particularly software solutions (taking up to 80 percent of the total VC share in coming years), more and more funding will go toward what is known as “frontier technology”.

What comes after the internet and mobile technologies supported by it? Personal rockets. Unmanned vehicles. And any and all other sci-fi fantasies that are quickly poised to be reality. In short, private space exploration, drones, and everything else that can carry society into a new tech reality is part of this investment space.

CBInsights published that 2015 saw a 118% increase in VC investment across the industry and 2016 and 2017 were poised for even stronger growth.

Another interesting trend – that is of particular use if you are deciding whether or not you are attractive enough to get a VC firm or angel investor interested – is that VC giving has become a “barbell”. Nearly all VC is either small scale or large scale in scope, going from giant VC companies to the “unicorns” with more than $1 billion valuations or from small VC firms that specialize in particular endeavors.

That trend fits with the data that, though 2017 is on track to be the biggest VC spending year this millennium, the investment volume, or number of actual companies receiving funding, has been declining for 5 years. More funding is going to bigger companies, and at later stages in their development. Firms are taking less risk and giving more to later growth stages in already established companies with proof of concept.

Things to Know about Venture Capital

Beyond the background of VC and the statistics and trends of where funding is and will go, what you really need to know about venture capital can be summed up in three ideas – most VC funded projects fail, there are many more alternate resources available to startups, and VC in many ways is more about relationship building and networking than financial backing.

75% of VC Backed Firms Fail

Harvard Business School lecturer Shikhar Ghosh published, from findings of research based on 2,000 companies that raised $1 million or more from 2004 to 2010, that as many as 75 percent of venture-backed companies do not return cash to investors. Up to 40 percent of those liquidate assets; investors lose all of their money in those cases.

It Is One of the Smallest Sources of Start-Up Funding

Venture capital expert Diane Mulcahy published in Harvard Business Review (2013) that “venture capital financing is the exception, not the norm, among start-ups. Historically, only a tiny percentage (fewer than 1%) of U.S. companies have raised capital from VCs.” She continues to report that while VC funding is actually contracting as compared to pre-2000 rates, other forms of startup capital are increasing dramatically. Angel investors funded more than 16 times as many companies as VCs did in 2011.

Also new internet-based networking resources like AngelList and crowdfunding sites that take micro-investments are taking more and more of a market share of the investment scene for startups and growth-stage companies, and their share is growing. In 2011 angels invested more than $22 billion in approximately 65,000 companies, whereas venture capitalists invested about $28 billion in about 3,700 companies.

Is Venture Capital Worth It?

Whether or not venture capital, or private capital investment in general, is worth it may be the most difficult question to answer for any startup or growth stage business. Trying to raise VC can be time-consuming and costly, and it will ultimately give away a good amount of your equity or initial profits. But if you don’t look for capital, you can end up stuck in a cash flow conundrum and fail to develop your idea or grow to make any money in the first place.

“When someone gives you venture capital, it’s like someone handing you a grenade with the pin pulled. If you know what to do with it, it can be very useful, if you don’t know what to do with it, it can blow up in your face,”

Wright Steenrod, a partner at Chrysalis Ventures.