Issue: Venture Capital Venture Capital By: Michael Fitzgerald Pub. Date: May 25, 2015 Access Date: September 26, 2021 DOI: 10.1177/2374556815590736 Source URL: http://businessresearcher.sagepub.com/sbr-1645-95837-2675461/20150525/venture-capital ©2021 SAGE Publishing, Inc. All Rights Reserved. ©2021 SAGE Publishing, Inc. All Rights Reserved. As money pours in for start-ups, can funds improve results? Executive Summary Venture capital in the United States has matured as an industry, and with maturity comes fear of complacency. Many of its stars are reaching retirement age, and the sector faces questions about its inability to beat stock market returns, let alone match its storied performance of the 1990s, when the industry and high tech both rose to prominence. New types of investing approaches such as crowdfunding; increased vigor and coordination by “angel” investors; and greater interest in start-ups by private equity firms, hedge funds and mutual funds mean venture capitalists are facing growing competitive pressure. The industry's clubbiness has brought questions about its lack of diversity, and fears of a new tech bubble raise concerns that VCs are fueling conditions for another economic downturn. Even so, global interest in finding the next great start-up is soaring, opening up more opportunities for venture capital. Overview As Etsy went public in April, venture capitalists watched closely. The pioneering artisan e-commerce site's initial public offering (IPO) valued the company at well over $1 billion, affirming what its investors had already said: Etsy was a rare commodity, a start-up worth $1 billion. In the parlance of the venture capital (VC) industry, it was a “unicorn.” 1 According to venture capitalist Aileen Lee, who popularized the term, one of those rare unicorns can return the value of an entire fund all by itself. 2 Writing in 2013, she noted that only 39 $1 billion companies had emerged in the previous decade, or less than 1 percent of the enterprise and consumer software companies founded with venture money. Only one, Facebook, was worth more than $100 billion—what she called a super-unicorn. But in the ensuing two years, unicorns have multiplied: There were 13 privately held unicorns in 2013, and by mid-May 2015 there were 107, no longer including post-IPO Etsy. 3 This herd of unicorns seemingly signals that venture capital is thriving as the industry approaches levels it last achieved 15 years ago in terms of buzz and investment capital: VCs invested nearly $48 billion in 2014, the most since 2000, when a high-tech bubble collapsed and sent the U.S. economy into a brief recession. 4 Moreover, the average deal size ballooned to nearly $8 million. Overall, venture capitalists raised $32.2 billion in 2014, according to PitchBook, which tracks the VC industry. 5 In the first quarter of 2015, they Executives of Etsy, the online crafts market, observe the first raised another $7 billion, including a $1.6 billion fund raised by Bessemer trade of the company's newly public stock on April 16, 2015. Ventures. 6 That's a lower quarterly average than in 2014, but still solid. The initial public offering valued Etsy at more than $1 billion, making it one of an increasing number of once-rare venture- But other signs are more troubling. Venture funds have not beaten the Dow capital-backed “unicorns.” (Paul Zimmerman/Getty Images) Jones industrial average over the past decade, and they have only barely beaten the S&P 500, meaning that investors are not getting the “multiples” they expect to get from risky venture capital investments. 7 One study found that just a few VC firms were responsible for most of the industry's returns. 8 The generally mediocre rates of return have caused people like Diane Mulcahy, the senior fellow at the Ewing Marion Kauffman Foundation responsible for its endowment investments, to question whether most VCs add any actual value to companies. “VCs have a great gig: They get paid well in fees, even if they lose money,” she says. Other problems are both deeper and murkier: Modern venture capital, which began taking shape in the 1970s, is hitting middle age, as is the high tech industry that created venture's biggest successes. Critics say the days are gone when a venture capitalist could put $1.2 million into a fledgling computer company and see that investment worth more than $200 million a few years later, as happened with a 1975 investment in Tandem Computers. 9 Quite simply, VC is not generating the high returns that it experienced in the 1990s and earlier, when both it and the technology sector were thriving. Meanwhile, some of the venture industry's biggest names are retiring or are close to retiring. Eugene Kleiner died in 2003, and Tom Perkins is no longer involved with Kleiner Perkins Caufield & Byers, long the Silicon Valley's signature firm; big-name partner John Doerr is 63. Donald Valentine of Sequoia Capital is in his 80s, and Michael Moritz, that firm's chairman, is 60, and has reduced his involvement with day-to-day investments because of illness. At New Enterprise Associates (NEA), founded in 1978 and the largest VC firm by assets under management ($15 billion), co-founder Dick Kramlich did not participate in its newest fund. 10 Page 2 of 22 Venture Capital SAGE Business Researcher ©2021 SAGE Publishing, Inc. All Rights Reserved. Venture capital can be the jet fuel for starting companies, boosting the economy and creating jobs. But day to day, it is a more mundane business. Venture capitalists are partners in a kind of specialized mutual fund that invests money for large institutions, such as pension funds and university endowments, promising better returns than stocks. It's a form of private equity, a class of assets considered alternative investments to cash, stocks and bonds, the three most common asset classes. Venture capitalists make their returns by providing money to entrepreneurs with great ideas but limited access to capital, and connecting those entrepreneurs with people in a position to make their business better— advisers, partners and customers for their product. In return, VCs earn what's called “2 and 20,” 2 percent management fees drawn from the overall fund they raised, and 20 percent of the carried interest, or the profits generated over the life of the fund, which typically runs 10 years. Some limited partners say that VCs are paid too much and return too little. Top 15 Venture Capital Investors in Start-Ups Amount invested in deals completed in 2014, in $U.S. millions Aileen Lee, founder and partner at Cowboy Ventures, in 2013 dubbed start-up firms worth $1 billion-plus as unicorns for their rarity. Such valuable venture-capital-backed companies have become notably more common since then. (Steve Jennings/Getty Images) Note: Firms are ranked on total capital amounts invested in early-stage deals. Data from PitchBook Platform, http://pitchbook.com/. Source: Tanya Benedicto Klich, “VC 100: The Top Investors in Early-Stage Startups,” Entrepreneur, Feb. 19, 2015, http://tinyurl.com/opq8aop Page 3 of 22 Venture Capital SAGE Business Researcher ©2021 SAGE Publishing, Inc. All Rights Reserved. Andreessen Horowitz of Menlo Park, Calif., topped the list of venture capital firms most active in early-stage investment in start-up firms in 2014, with more than $1 billion in deals completed that year. The company, founded by two former Netscape executives, has more than $4 billion under management. Some sovereign wealth funds—investment funds owned by governments—have tried to make their own investments out of dislike for the venture capital funding model and the inconsistent investing results VC firms generate. Were these to succeed, they could deprive VCs of a major source of institutional dollars. So far, though, the sovereign wealth funds have done far worse on their own. 11 Steven Kaplan, a professor of entrepreneurship and finance at the University of Chicago's Booth School of Business, argues that venture capital is a cyclical industry emerging from a down cycle. He points out that funds raised between 2008 and 2012 have outperformed the S&P 500 by about 2 percent a year. Mulcahy is not impressed, arguing that these are paper profits based on valuations and that the real profits won't be known until companies in which the funds have invested actually go public or are purchased. This debate will play out over the next several years, and she believes VC will struggle to create better net returns than the public markets. One thing that's not debatable is the shift in the VC industry. VCs once routinely invested in companies as they were forming, but have ceded much of that traditional role in funding young companies to “angel investors,” who often work alone and invest only their own money. While large VCs still maintain seed funds and will directly fund entrepreneurs they've worked with before, “that lower end of the market has been abandoned by VCs,” says Josh Lerner, a professor of investment banking at Harvard Business School. He cites technology developments such as online platforms, which allow groups of angel investors to band together to invest, for the shift. Other options for newly formed companies include “accelerators” and incubators that invest small amounts, $50,000 or $100,000, in entrepreneurs’ firms, and introduce them to VCs after they have established their business model. Crowdfunding platforms, which allow much broader groups of people to invest in start-ups, are also on the rise. VCs are drawing increased scrutiny on another front, too: At a time when income inequality is spawning protest movements and political pressure, the payments venture capitalists can receive, and the role they play in funding companies that sometimes destroy more jobs than they create, face criticism.