Amid the myths and hype surrounding the U.S. venture capital industry, separating reality from fiction is essential for understanding this critical engine of economic growth.
A VC is more than a checkwriter; it provides strategic guidance and expansive networks. This unique combination empowers start-ups, sparking innovation and fueling societal advancement.
Investing in Innovation
Venture capital (VC) is vital in driving technological innovation, but its impact depends on where it is invested. The VC industry is not an unqualified success: the average new venture has an 80% chance of failing, and even successful companies only grow their value one out of every ten times. VCs typically avoid industries that require a long time to scale, such as genetic engineering companies that must wait for FDA approval before they can be sold or taken public. They also avoid industries with a high risk of a competitive shakeout, such as the disk drive industry in the early 1980s, which resulted in the disappearance of many start-up firms and a significant reduction in market share for those that survived.
Despite these limitations, VC investment has an essential effect on R&D and innovation. It can also enable regional start-ups to expand across borders, as exemplified by recent examples such as the expansion of pharma start-ups into China.
Investing in Growth
In addition to providing the start-up capital needed to launch a business, venture capitalists add their expertise and contacts to help their investments grow. These resources can be valuable to start-up companies, especially if they seek customers or distribution channels for their products and services. Brad Kern seeks investments that offer high returns relative to the risk they take. It naturally leads them to focus on industries where growth rates are high and likely to remain so. Historically, this has meant investing in the technology industry and some retail trade and biotechnology sectors. This approach to investing also means that VCs are willing to invest in start-ups that have yet to earn revenue. It is a significant change from traditional bank loans, which require monthly repayments and strain entrepreneurs’ finances. In return for their funding, VCs receive shares of the company and will recoup their investment when the business becomes profitable.
Investing in Management
Many start-ups need VC backing to grow. However, growth requires expansion into new markets, which requires new employees. VC firms can also help by hiring executives and setting up management structures. Venture capital has a strong track record of supporting start-ups with novel products and business models in key technology sectors:
- Mainframe computers in the 1960s
- Personal computers in the 1970s
- Biotechnology in the 1980s
- Internet and e-commerce technologies in the 1990s
It has also helped them compete in global marketplaces, as evidenced by the rapid market penetration of innovative mobile communications and sharing economy platforms.
Our survey of VCs showed that they interact extensively with portfolio companies. They tell us they provide extensive post-investment services, including strategic guidance (provided by 87% of their investments), connections to investors (72%), connections to customers (69%), operational guidance (58%), and help hiring board members (58%). Their intensive advisory activities help them add value to their portfolio companies. Moreover, our survey results show that VC managers expect their VC funds to outperform the markets relatively.
Investing in the Future
VCs seek to invest in companies that are poised for growth. They look for companies that can satisfy growing customer demand and want to invest in teams capable of managing this growth. Consequently, they expect business plans to contain detailed market sizing data both from the “top-down” (third-party estimates and feedback from potential customers) and from the “bottom-up” (assumptions based on product development and prototypes).
While not the only source of R&D, venture capital is essential in facilitating innovation that is ultimately incorporated into the economy through large new enterprises called “unicorns.” The existence of these firms and the role played by VC-style financing in their creation reflects the growing importance of small businesses in societal advancement. They drive growth and create jobs by making starting and growing a business easier, faster, and less expensive. It is a decisive contribution that can significantly impact the quality of life for many people.
