Venture Capital

What is Venture Capital?

Venture Capital or VC is the financial capital that is provided to early stage, high potential, high risk, growth startup companies with perceived long term growth potential. Venture Capital is contributed by wealthy investors, investment banks and other financial institutions that need investments to partnerships. This kind of raising capital is mainly found in new companies or ventures which have limited operating history and which cannot raise funds by issuing debt. Other than holding equity they also make decision for the company. They are associated with job creation and nearly 2 million businesses are created in the USA of which 600 to 800 of them get VC funding. If one goes by the National Venture Capital Association, 11% of private sector jobs are backed by venture revenue accounts.

Private Equity

Private Equity consists of funds and investors that make investments into private companies. They are also involved in the buyout of public companies that result in a delisting of public equity. Private Equity is also raised to make new acquisitions or to strengthen a balance sheet. Institutional investors and accredited investors who lend large sums of money for a long period of time basically comprises of private equity. These investments often demand a long holding period to allow for the turnaround of the company or a liquidity event such as IPO or sale to a public company.

Private equity is realized through one of the following:

  • Initial Public Offer
  • A merger or acquisition
  • Recapitalization

Venture capital is a type of equity investment suits for start-up companies that require a lot of capital. In general, venture capital investments are higher risk investments with above average returns. Venture capitalists will receive suitable shares of the company in return for their investments. The funds getting mobilized through venture capital would be from a group of wealthy investors, investment banks and other financial institutions. This type of funding is popular in new companies, emerging industries and joint ventures also.

Research study estimates

  • The private equity and venture capital funded companies are growing faster than non-private equity and venture capital funded companies in the market place
  • These firms are adding more jobs to the economy and growing at the rate of 32% as compared to 6% non -private equity firms
  • Most of the top executives in the companies feel that without venture capital funding these companies would have not existed

History of venture capital funding

  • 1959 - Fairchild Semiconductor was funded by Venrock Associates
  • 1970 - Venture capital firms focused on startup and expanding companies
  • 1974 - Temporary downturn due to stock market crash and non-acceptance on this type of funds
  • 1978 - Venture capital raised on an average $750 thousands and the first great year for Venture capitalists
  • 1980 - Venture capital investment returns were very low due to inexperienced venture capital managers
  • 1990 - It was a boom year for the global venture capital firms due to large number of initial public offerings happened in US history
  • 2000 - Due to NASDAQ crash and technology slump resulted in losses from high valued and non -performing new companies as per the expectations
  • 2003 - Venture capital funds withered about half of its capacity from the year 2000

Types of venture capitalists

  • Public and private international venture capital firms
  • Small Business Investment Companies(SBIC)
  • Corporate venture capital units

Features of venture capital firms

Board representation

Venture capitalists play a pivotal role in strategic functions of the companies apart from mobilizing capital for its ventures. In order to protect their investments, they would like to represent in company's board activities.

High risk and high returns investments

venture capitalists appreciates innovative ideas but they look for higher returns in the range of 25 percent to 40 percent.

Business exit

Vventure capitalists would like to move out of the business after specified period of time usually between 3-7 years after investments in the business.

Industry expertise

venture capitalists prefer to invest capital in specific industries or businesses due to their good knowledge base.

Project evaluation process - Venture capitalists

Before investing in any projects, venture capitalists will follow the various steps to evaluate the project:

  • Preliminary screening
  • Detailed Business plan and
  • Due diligence - Business and legal

Venture capital advantages

  • Venture capital can be used as a financial tool for start-up and small and medium companies
  • Venture capital acts as a source of job creation
  • Venture capital acts as source of sanctioning capital for growing companies who don't qualify for bank loans approval
  • Venture capital plays a vital role in improving the corporate governance and accounting standards of those companies
  • Venture capital is used as an economic tool in developing economies

Geographical spread - Venture capital funding

  • United States - During 2006, VC's invested about $6.6 billion in 797 deals and research survey predicts that Venture capital investments will be around $20-29 billion in 2007
  • Europe - In the year 2006, the top three countries in venture capital investments were the United Kingdom (515 deals worth of €1.78bn, France(195 deals worth of €875m) and Germany(207 deals worth of €428m)
  • In China, venture capital investments doubled from $420 thousand in 2002 to almost $1 million in 2003
  • In India, the venture capital investments during 2006 is $3 billion and expected to reach $6.5 billion

Thus, venture capital ahs become an important source of mobilizing funds for start up companies and small - medium companies which comes out with innovative ideas in the market place. Meanwhile, VC investments are risky but having the potential for getting higher returns over a long period of time. The venture capitalists have been the source of creation of world best companies such a s apple, Compaq, Intel, Sun Microsystems etc. Without VC investments, we wont be seeing these companies today physically.

Origins of Modern Private Equity

Modern Private Equity

The concept of modern private equity took shape in 1946 when the first venture capital firms were formed. The period of 35 years from 1946 up to 1970s can be described by reasonably small amount of private equity investment, undeveloped business and little awareness of private equity industry.

After 2nd World War, in 1946, establishment of two venture capital firms, American Research and Development Corporation. (ARDC) and J.H. Whitney & Company, is said to be true private equity investments.

Georges Doriot, who is considered as the ‘father of venture capitalism’, founded ARDC with Ralph Flanders and Karl Compton to promote private sector businesses run by army personals after coming back from 2nd World War. ARDC was the first private equity firm to raise capital from other sources except wealthy people. ARDC’s most successful deal was its $70,000 investment in Digital Equipment Corporation (DEC) in 1957. After the initial public offering (IPO) of DEC in 1966, ARDC’s investment was valued at around $355 million which is more than 500 times of its initial capital.

This success story inspired former employees of ARDC and they tried to establish other venture capital firms such as Greylock Partners and Morgan, Holland Ventures. By 1971 ARDC had invested in over 150 companies. In the same year Doriot got retired. Doriot merged ARDC with another company Textron in 1972.

John Hay Whitney had founded J.H. Whitney & Company in 1946 with his partner Benno Schmidt. Whitney was in investment business since 1930s. With help of his cousin Cornelius Vanderbilt Whitney, Whitney had established Pioneer Pictures in 1933 and acquired 15% share in Technicolor Corporation. He is remembered for his remarkable investment in Florida Foods Corporation. The company had developed a new technique to deliver nutrition to American soldiers. Afterward the company was known as Minute Maid orange juice and The Coca-Cola Company acquired it in 1960. J.H. Whitney & Company's investment in leveraged buyout transactions continued and the company gained $750 million for its 6th institutional private equity fund in 2005.

From the time when the modern private equity industry started in 1946, the period has been differentiated as follows:

  • Early history of private equity: 1946 – 1981: This phase is described as approximately small amount of private equity investment, undeveloped organizations and less acquaintance with private equity industry.
  • 1st boom and bust cycle: 1982 – 1993: This era can be portrayed by the remarkable rush in leveraged buyout movement financed by junk bonds and significant buyout of RJR Nabisco. However, during the later part of 1980s and early 1990s, there was a downfall in leveraged buyout industry.
  • 2nd boom and bust cycle: 1992 – 2002: After incidents such as savings and loan disaster, business scandals, fall in real estate market and downturn of the early 1990s, this period witnessed the surfacing of more institutionalized private equity firms, eventually concluding the substantial Dot-com bubble in 1999 and 2000.
  • 3rd boom and bust cycle: 2003 – 2007: During this period, leveraged buyouts touched unparalleled dimension and the institutionalization of private equity firms was represented by initial public offering of the Blackstone Group in 2007.

Venture capital

The term ‘venture capital’ (VC) was coined by Benno Schmidt, the partner of J.H. Whitney & Company in 1946. ‘Venture’ is shortening of the word ‘adventure’ as nature of the investment is risky. Venture capital the financial support provided to startup companies with higher potential, novel technology and business model. Usually, venture capital investment takes place after seed funding round because this is the stage where the company starts to generate cash on its own through an ultimate realization event, for instance an IPO or trade sale of the company. The venture capital fund makes cash by possessing equity in the companies it invests in. Hence, all venture capital can be private equity but all private equity cannot be termed as venture capital.

Venture capital was known as development capital before 2nd World War and only wealthy people could make venture capital investments. However, in 1958 Small Business Act was passed in the United States and it opened the way for the U.S. Small Business Administration (SBA) to authorize private "Small Business Investment Companies" (SBICs) to finance small entrepreneurial businesses.

Venture capital plays an important role in small companies that have inadequate operating history to generate revenue on their own. These companies can not afford a debt offering or a bank loan. In this situation venture capitalists provide the financial support to the company and get control over major portion of its ownership and important decisions.

Job creation is another aspect of venture capital. In the USA, around 2 million businesses are created every year, out of which 600 to 800 are supported with venture capital funding. As per reports of the National Venture Capital Association, 11% private sector employment comes from companies which get venture capital fund. The report also states that venture supported revenue accounts for 21% of US GDP.

Early venture capital and the growth of Silicon Valley

Venture Capital at early stage provides funds to startup with high potential. It makes profit by owning equity of the funded company. Private Equity is a subset of the Venture Capital. They invested primarily in the breakthrough sectors, such as, electronics, medical, and many more. In order to understand the growth of Silicon Valley one has to first understand the pivotal role played by Venture Capital in its development.

Venture Capital

Venture Capital (VC) in easy terms is the financial capital that is provided at the early stage to the high potential startup companies which were in earlier times funded by the wealthy individuals and families—the Wallenbergs, Vanderbits, and Rockefellers. The VC fund earns money by owning the equity of the company, which are high technology industries like biotech, IT and Software. Therefore, we can say VC is a subset of Private Equity.

Private Equaity

Private Equity in the beginning was the domain of wealthy individuals and families. In 1946 two Capital firms American Research and Development Corporation (ARDC) and J.H.Whitney  &  Company were formed. ARDC became the first institutional private equity investment firm that raised funds from other sources. JH Whitney also followed on similar lines and until 2005 raised $750 million for its sixth institutional private equity fund.


During the 60s and 70s, VC firms started their investment activities primarily on companies which were exploiting breakthroughs in electronic, medical, and data processing technologies. Fairchild Semiconductor is the first venture backed startup funded in 1959 which produced first commercially practical integrated circuit.


In 1974, with the stock market crash the VC firms suffered a temporary downturn with the investors becoming wary of this new kind of investment. Growth in the VC industry was limited throughout the 1980s and the first half of the 1990s, increasing from $3 billion in 1983 to just over $4 billion more than a decade later in 1994. Lastly, during the late 90s the VC firms have benefitted from the huge surge of interest in the nascent Internet and computer related technologies.

Venture Capital Investment Firms in 1980’s

Venture capital is money that is provided by the investors to small businesses or start-up companies with long-term goal potential and also includes managerial and technical expertise. The venture capital is done from a group of investors, investment banks, or any other financial firms that pool such investments or partnerships and this fund earns money by owning equity in the companies. These investments are done in high risk but it is capable of giving impressive results if invested in the right venture. Private equity (finance) is type of investment which is aimed at gaining significant or complete control of the firms in expecting high returns. As the name implies, investments are made directly into private companies resulting in de-listing of public equity. Sometimes the private equity firms will pool funds together to have very large public companies private and the size of this market has grown steadily since the 1970s. In early 1980s, the public success of the venture capital industry gave rise to an impressive proliferation of venture capital investments companies and from few companies at the start of the decade, there were more than 650 companies by the end of 1980s. The capital managed by these companies increased from $3 billion to $31 billion over the decade. In addition to increase competition among the companies the growth of the industry was slowed down by sharp declining returns. By the end of the 1980s, the returns of the venture capital were relatively low and growth in venture capital companies remained
limited throughout 1980s.

Private Equity Crash and Stagnation in the LBO market

In order to understand the Private Equity Crash of 2000-2003 one needs to have a fair knowledge of the terms Venture Capital (VC) and the Leverage Buyout market. These are the two sub industries which experienced downfall along parallel although interrelated tracks.

The end of the 20th century saw the end of the dot com bubble and the growth in the venture capital. The private equity firm achieved new levels of scale and institutionalization as leverage buyouts reached unparallel size.

The Nasdaq crash in March 2000 shook the entire Venture Capital Industry as valuations for startup technology companies collapsed. The next two years, the venture firms saw the selling of large portions of their investment. It became half of its size in 2003 then what it was in 2001. With the revival of the Internet driven environment the Venture Capital environment also revived. However, it did not reach its mid 1990s level and not to mention its peak in 2000.

With the collapse of the Venture Capital market, the LBO market activity also declined. From the year 1996 to 2000, LBO firms invested heavily in the telecommunications sector and profited from it, but it suddenly fell in 2001. As many as 27 major telecommunication companies with liabilities worth more than $100 million filed for bankruptcy protection.

Two of the largest and most active private equity firm in the 1990s, which were most affected by the bursting of the internet and telecom bubbles were—Tom Hicks' Hicks Muse Tate, and Forst & Ted Forstmann Little and Company. Hick Muses suffered a loss of $1 billion whereas Forstmann Little had to return the $96 million investment to the state of Connecticut.

In Europe, as the market began to mature the LBO activity also increased. In the year 2001, European buyout activity was worth $44 billion where as in US it was $10.7 billion. This was due to the fact that six LBOs in excess of $500 million were completed in 2001 whereas in 2000 it was only 27.