In many ways, the story of venture capital is the story of commerce itself. Every venture capitalist will tell you that the business begins in the fifteenth century, when Christopher Columbus sought to travel westward instead of eastward from Europe to reach India. His visionary idea did not find favor with the king of Portugal, who refused to finance his venture. After visiting many merchant banks, Queen Isabella of Spain decided to “fund” him for his venture. And so the story goes: The concept of venture capital was born.
The modern venture capital industry as we know it today began taking shape in the post–World War II era. In 1946, American Research and Development Corporation was founded with the explicit goal of making investments in promising new companies. They evolved the basic business model for the venture capital industry. Their venture capital investment in Digital Equipment provided them with an astounding 101 percent annualized return on investment. Suddenly, many large capital pools embraced the idea of allocating a portion of their investment capital into new business ventures.
In the mid-1950s, the U.S. government recognized the need for risk capital and promoted small business investment companies (SBICs). This gave rise to an entire era of public SBICs that invested shareholder capital into small private ventures. In the late 1960s, the SBIC industry followed the seven-year slump of the U.S. stock market, and most of the small business investments they made also failed. The situation began to look up in the late 1970s, based on a massive reduction in the capital gains tax rate and a number of high-profile IPOs by venture-backed companies such as Federal Express and Apple Computer.
The public market valuations for small and micro cap firms send a signal to the private equity investor about whether the markets are ready and able to absorb new IPO opportunities. The IPO is potentially the most lucrative exit strategy for the venture capitalist. If the expectation in the small and micro cap arena is of multiple expansions, venture capitalists have a direct market signal to be more aggressive in raising and cultivating opportunities that will ultimately appear in the public markets. This creates a certain boom-and-bust cycle that is an accurate barometer of the outlook for both venture capital and micro cap investments.
Venture capital investing is a long-term proposal. The typical holding period for a private venture capital investment is 3 to 7 years, although many venture capital investment partnerships are structured to last 10 years or longer. So the typical venture capital investor has a long-term time horizon and the ability to be involved in an investment vehicle that may show little opportunity for liquidity over 7 years or more. And because institutional investors are generally the only ones who have the size and scale to make these types of investments, the minimum investment amounts are often $1 million or more. It takes real money just to get to the table in venture capital investing. That is not the case for micro cap investing.
As we have discussed, diversification is important in the context of the overall investment portfolio. It is also important in the context of the venture capital investment. As a venture capital manager described it, most venture capital investment pools are composed of one or two home runs and one or two losers, and the balance are the walking dead! The statistics about venture capital from a number of comprehensive studies confirm that description. About 7 percent of the venture deals in any given pool provide over 50 percent of the portfolio total returns. These would be the home runs. On average, about 15 percent of the deals go broke or produce a total loss of the invested capital. These are the losers. The walking dead are the real problem for the venture capitalist. These are the approximately 40 percent of the deals that produce a loss on the investment or the remaining 38 percent that produce a below hurdle rate of return and that may offer little or no hope for a meaningful exit strategy for the venture capital investor. The ways the probabilities work suggest that single venture capital investment has about a fifty-fifty chance of producing some loss for the investor. The typical fiduciary representing an institutional investor in the venture capital sector normally responds to these odds by being invested across a sufficient number of venture capital pools to create a well-diversified portfolio of venture capital opportunities. In addition, the institutional investor often invests in venture capital pools that target different venture strategies.