What is Venture Capital Investing?

Another excerpt from “The Little Book of Venture Capital Investing” (Wiley, 2014)

venture capital investing book author

What is Venture Capital Investing?

Venture capital investing is a lot like the old baseball adage: you win some, you lose some and some get rained out. There is no secret formula or guaranteed path to success; especially in the field of venture capital investing. Many venture capitalists have lost their entire investment when the once-brilliant ideas they funded foundered in the competitive marketplace or got torpedoed by even greater innovations.

Sand Hill Road, the legendary 3.5-mile stretch of concrete which runs east from I-280 to El Camino Real in Menlo Park, California, is the financial epicenter of Silicon Valley. It is littered with the fading memories of companies and grand ideas you’ve never even heard of. It is also home to many early investors in businesses that went on to become household names; calculated risks which made many of them quite comfortable.

The returns on the initial investment are just the tangible rewards for being a venture capitalist. Many who live and work along this short stretch of road which skirts the north side of Stanford University are driven by more than money.

Reid Hoffman is a perfect example; the 45-year old partner at Greylock Partners has been in on the initiation of over 80 startups including such game-changers as PayPal and LinkedIn. He sits on the Board of Directors for Kiva.org and is known as the consummate connector in Silicon Valley. He genuinely cares about people and making the world a better place. As LinkedIn CEO, Jeff Weiner says of Hoffman

“His true north is making a positive, lasting impact on the world in a very profound way.”

Hoffman is a self-identified liberal who still drives the 2002 Acura he purchased with his share of the PayPal buyout. He probably understands the angst underscoring the Occupy complaint, but it would be an incredible stretch of credibility to paint Reid Hoffman with the scarlet “1%” label.

How does one become a venture capitalist?

For many, like Bill Joy, it was a natural progression. Born in 1954, Bill grew up in the northern Detroit suburb of Farmington Hills, Michigan. He obtained a bachelor’s degree in electrical engineering from the University of Michigan and by 1979 had completed a master’s degree in computer science from the University of California, Berkeley. He also holds an honorary Ph.D. in engineering from the University of Michigan. As a graduate student at Berkeley, Joy designed and wrote Berkeley UNIX, the first open source operating system with built-in TCP/IP, making it the backbone of the Internet. He founded Sun Microsystems in 1982 and was a key designer involved with a number of Sun technologies, including the Solaris operating system, the SPARC microprocessor architecture and several of its implementations, and the Java programming language.

Bill is named on more than 40 patents. In February 1999, his many industry contributions were recognized in a FORTUNE magazine cover story that called him the “Edison of the Internet.” His accomplishments, the product of his keen intellect and inquisitive nature, resulted in substantial financial rewards. This prompted him to pursue interests in other areas.

In 2005, Bill Joy joined Kleiner Perkins Caufield & Byers, one of the first Sand Hill Road VC firms and the company which had provided the startup capital for Sun in 1982. Joy helped develop KPCB’s strategy of funding game-changing technologies that broadly address the twin problems of climate change and sustainability. His ventures included investments in wind, solar and thermoelectric power generation, low-cost electrical energy storage, renewable fuels and green chemicals from non-fuel sources, low-embodied-energy materials and energy-efficient electronics. He now serves as a Partner Emeritus at the firm.


An Overview of the Venture Capital Industry

Like Bill Joy, most venture capitalists (VCs) come into the industry from another field in which they have experienced success or which holds a great deal of interest for them. There is a high tech legend that Bill Joy and futurist Ray Kurzweil were having drinks in a hotel bar one night and got into a rather protracted discussion about GNR technologies – genetics, nanotechnology, and robotics – and the possibilities of reaching a point in the future where the human race becomes one with machine. This is a favorite and recurring theme in Kerzweil’s writings, but it so disturbed Joy that he developed a fund to invest in GNR for the sole reason of monitoring the progress of the sector’s development.

Reid Hoffman started SocialNet.com as a way for students on the Stanford campus to have a way of connecting with others who shared their interests. He was about seven years ahead of the social media phenomenon, but the interest has definitely influenced his investment strategies. It led to him doing everything right when he rolled out LinkedIn several years later.

VCs don’t typically use a lot of their own money. That is usually an activity reserved for what is known as an Angel Investor and typically involves investments of $1-million or less. Venture capitalists form a firm and start a fund which is often designated for a specific industry sector. The fund will attract money from pension funds, endowments, foundations and high-net-worth individuals (HNWs) and family offices who are interested in either investing in that particular sector or just looking for the higher than normal return that is the attraction and the pitfall of venture capital investing.

When all goes as planned, the VC finds an entrepreneur with the next big idea, invests the fund’s money for an equity position, mentors the entrepreneur’s management team to the point where the new company is showing success and then “exits” the investment through either an initial public offering (IPO) on the stock market or, more commonly, arrange a sale of the company through a merger with or acquisition by another firm (M&A). The return on the growth of the VC’s equity position is then returned to the fund and paid out to the fund’s investors on a prorated basis.

According to statistics of the National Venture Capital Association (NVCA),

  • 40% of all ventures fail to ever show a positive return,
  • 40% may eventually break even, and
  • 20% ever show a profit.

Of that “profitable” group, only about 10% become ever come close to being the next LinkedIn, Google or Facebook. Those success stories are what keep the lights on in the office buildings along Sand Hill Road and elsewhere across the country.

Venture capital activity has a significant impact on the U.S and global economies. Venture capital is a catalyst for job creation, innovation, technology advancement, international competitiveness and increased tax revenues. According to the 2011 Venture Impact study, produced by IHS Global Insight, originally venture-backed companies accounted for 11.87 million jobs and over $3.1 trillion in revenue in the United States (based on 2010 data). Those totals compare to 21% of GDP and 11% of private sector employment.

So how is the VC industry doing these days? For the fourth quarter of 2012, the NVCA issued a press release with the headline


According to the release, $1.4 billion was raised from eight IPOs during the fourth quarter of 2012. This was a decline in volume from the preceding quarter, but a 23% increase in total dollars raised. For the full year, 2012 saw 49 IPOs raise a total of $21.5 billion, driven largely by the Facebook offering. This was the strongest annual period for IPOs, by dollar value, since 2000. M&A deals were down 11% from 2011, with 120 disclosed value deals returning $21.5 billion for full year 2012.

As detailed in other Little Books, indexing and thoughtful asset allocation is probably a solid choice for many investors’ core holdings.  But for those seeking exceptional gains on a long-term investment horizon, alternative investments like private equity (including venture capital) can offer an uncorrelated – and often highly lucrative – complement to an otherwise staid investment plan.

Just like other markets, venture capital experiences periodic investment cycles. Coming off the historic dot-com boom and Great Recession that followed, venture capital has recently taken some hits but is poised for a new run.

“The lesson of the late ‘90s is that venture capital can be powerful at times,” said Greg Turk director of investments for the $37 billion Teachers’ Retirement System of the State of Illinois. The System is increasing its allocation to venture capital to diversify its portfolio.

“If you don’t have it, you might miss out if venture capital returns to outperform again.”


Not your Grandfather’s Venture Capital

“Hold on a second”, you say. “Building tangible economic value sounds great, but aren’t private equity and venture capital investments only available to highly sophisticated, ultra-wealthy individuals or institutional investors?”

The answer is yes… and no. Historically, your grandfather’s venture capital tended to be a closed club to which average investors felt they could not apply. But market competition is causing venture capital to evolve in exciting new ways which I’ll tell you about in the chapters to come.

Excerpt from “The Little Book of Venture Capital Investing” by Louis C. Gerken and Wesley A. Whittaker. Published February 2014 by John Wiley & Sons, Inc. © 2014. All Rights Reserved.

Available from Amazon at http://www.amazon.com/Little-Book-Venture-Capital-Investing/dp/1118551982/ref=pd_rhf_dp_p_d_1

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