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Venture Capital

How Venture Capital Works

by Bob Zider

From the Magazine (November–December 1998)

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Summary.   
The popular mythology surrounding the U.S. venture-capital industry derives from a previous era. Venture capitalists who nurtured the...more
Invention and innovation drive the U.S. economy. What’s more, they have a powerful grip on the nation’s collective imagination. The popular press is filled with against-all-odds success stories of Silicon Valley entrepreneurs. In these sagas, the entrepreneur is the modern-day cowboy, roaming new industrial frontiers much the same way that earlier Americans explored the West. At his side stands the venture capitalist, a trail-wise sidekick ready to help the hero through all the tight spots—in exchange, of course, for a piece of the action.
As with most myths, there’s some truth to this story. Arthur Rock, Tommy Davis, Tom Perkins, Eugene Kleiner, and other early venture capitalists are legendary for the parts they played in creating the modern computer industry. Their investing knowledge and operating experience were as valuable as their capital. But as the venture capital business has evolved over the past 30 years, the image of a cowboy with his sidekick has become increasingly outdated. Today’s venture capitalists look more like bankers, and the entrepreneurs they fund look more like MBAs.
The U.S. venture-capital industry is envied throughout the world as an engine of economic growth. Although the collective imagination romanticizes the industry, separating the popular myths from the current realities is crucial to understanding how this important piece of the U.S. economy operates. For entrepreneurs (and would-be entrepreneurs), such an analysis may prove especially beneficial.

Venture Capital Fills a Void

Contrary to popular perception, venture capital plays only a minor role in funding basic innovation. Venture capitalists invested more than $10 billion in 1997, but only 6%, or $600 million, went to start-ups. Moreover, we estimate that less than $1 billion of the total venture-capital pool went to R&D. The majority of that capital went to follow-on funding for projects originally developed through the far greater expenditures of governments ($63 billion) and corporations ($133 billion).

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Where venture money plays an important role is in the next stage of the innovation life cycle—the period in a company’s life when it begins to commercialize its innovation. We estimate that more than 80% of the money invested by venture capitalists goes into building the infrastructure required to grow the business—in expense investments (manufacturing, marketing, and sales) and the balance sheet (providing fixed assets and working capital).
Venture money is not long-term money. The idea is to invest in a company’s balance sheet and infrastructure until it reaches a sufficient size and credibility so that it can be sold to a corporation or so that the institutional public-equity markets can step in and provide liquidity. In essence, the venture capitalist buys a stake in an entrepreneur’s idea, nurtures it for a short period of time, and then exits with the help of an investment banker.