What Is Venture Capital?
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
The composer of the term "venture capital" is unknown, and there is no standard definition of it. It is, however, generally agreed that the traditional venture-capital era began in earnest in 1946, when General Georges Doriot, Ralph Flanders, Karl Compton, Merrill Griswold and others organized American Research & Development (AR&D), the first (and, after it went public, for many years the only) public corporation specializing in investing in illiquid securities of early stage issuers.
One way to define traditional "venture capital," therefore, is to repeat General Doriot's rules of investing, the thought being that an investment process entailing Doriot's rules is, by definition, a venture-capital process. According to Doriot, investments considered by AR&D involved:
- new technology, new marketing concepts, and new product application possibilities;
- a significant, although not necessarily controlling, participation by the investors in the company's management;
- investment in ventures staffed by people of outstanding competence and integrity (herein the rule often referred to in venture capital as "bet the jockey, not the horse");
- products or processes which have passed through at least the early prototype stage and are adequately protected by patents, copyrights, or trade-secret agreements (the latter rule is often referred to as investing in situations where the information is "proprietary" (proprietary information));
- situations which show promise to mature within a few years to the point of an initial public offering or a sale of the entire company (commonly referred to as the "exit strategy");
- opportunities in which the venture capitalist can make a contribution beyond the capital dollars invested (often referred to as the "value-added strategy").
General Doriot's boundary conditions are to be treated with great deference because it is commonly agreed that Doriot is the single most significant figure in postwar traditional venture capital. Not only did he provide AR&D with its primary guidance (until it was acquired by Textron), but he also introduced a significant percentage of today's senior venture capitalists to the business through the courses he taught at Harvard Business School. And he showed the world how a traditional venture-capital investment strategy could produce enormous rewards when AR&D's modest investment in Digital Equipment Corporation (DEC) ballooned into investor values in the billions.
Parenthetically, in the eyes of the public of his day, Doriot's record at AR&D included only a few "home runs"–DEC in particular–and a bunch of losers, leading inexperienced observers to conclude that a well-managed venture portfolio should concentrate on the long ball, so to speak–the one investment that will return two or three hundred times one's money and justify a drab performance by the rest of the portfolio. This fallacious conclusion fostered the 1960s notion that an ultra-high-risk strategy is characteristic of venture-capital investing, with managers plunging exclusively into new and untried schemes with the hope of "winning big" every now and then. In fact, the AR&D strategy was never tied to the solo home run. Moreover, venture strategies have become highly varied. Some venture pools focus in whole or in part on late-round investments: infusions of cash shortly before the company is planning to go public, for example. Moreover, as outlined subsequently, buyouts involving mature firms are a popular venture strategy, as are so-called turnarounds, investments in troubled companies, including some actually in bankruptcy. And some funds are hybrids, sharing more than one strategy, even including a portion of the assets invested in public securities. The point is that a venture manager balances risk against reward; a "pre-seed" investment should forecast sensational returns, while a late-round purchase of convertible debt will promise a more modest payoff.
The term "venture capital" is grammatically multifaceted. General Doriot's exegesis specifies a certain type of investment as characteristic of the venture universe. He assumes, a priori, the proposition that venture capital involves a process, the making and managing (and ultimately selling) of investments. In addition, the phrase is sometimes used as an adjective applied to players in the game; that is, "venture-backed companies," meaning the portfolio opportunities in which the venture-capital partnerships or "funds" invest. The phrase becomes a noun when it describes the capital provided by individuals, families, and firms, which entities, along with the partnership managers, are called venture capitalists.
In terms of the people involved, venture capital is an intense business. The symbiotic relationship between the venture capitalist and his investment (assuming he is the "lead investor," meaning the investor most closely identified with the opportunity) is such that each professional can carry a portfolio of no more than a handful of companies. The investors are usually experienced professionals with formal academic training in business and finance and on-the-job training as apprentices at a venture fund or financial institution. Their universe is still relatively small; they and their advisers tend to be on a first-name basis, veterans of a deal or two together. And the work is hard, particularly since on-site visits impose an enormous travel burden.
The venture-capital process, before it was so labeled, has existed for centuries; antedating American Research & Development, it is as old as commercial society itself. In the last century, for example, Vanderbilt interests financed Juan Trippe in the organization of Pan American Airways, Henry Ford was financed by Alexander Malcolmson, and Captain Eddie Rickenbacker was able to organize Eastern Airlines in the 1930s with backing from the Rockefellers. However, the era of professionally managed venture capital-pools of money contributed by unrelated investors and organized into separate legal entities, managed by experts according to stated objectives, set forth in a contract between managers and investors, describing a structured activity, an activity that conforms to definite (albeit changing) patterns and rules-is a process that dates from the organization of AR&D.
In sum, the term venture capital can be applied in a number of ways: to investments, people, or activities. With full appreciation for the multiple uses of the term, the thrust and emphasis of this book (although by no means exclusively) is on venture capital of the type which is compatible with the Doriot rules. First, venture capital is an activity involving the investment of funds. It ordinarily involves investments in illiquid securities, which carry higher degrees of risk (and commensurately higher possibilities of reward) than so-called traditional investments in the publicly traded securities of mature firms. The venture-capital investor ordinarily expects that his participation in the investment (or the participation of one of the investors in the group which he has joined, designated usually as the "lead investor") will add value, meaning that the investors will be able to provide advice and counsel designed to improve the chances of the investment's ultimate success. The investment is made with an extended time horizon, required by the fact that the securities are illiquid. (In this connection, most independent venture funds are partnerships scheduled to liquidate ten to twelve years from inception, in turn suggesting that a venture-capital investment is expected to become liquid somewhere around four to six years from initial investment.)
Since the most celebrated rewards in the past have generally accrued to investments involving advances in science and technology to exploit new markets, traditional venture-capital investment is often thought of as synonymous with high-tech start-ups. However, as stated earlier, that is not an accurate outer boundary, even in the start-up phase. For example, the technology of one of the great venture–capital winners–Federal Express–is as old as the Pony Express, and it would take a great stretch of the imagination to perceive of fast-food chains such as McDonald's as involving additions to our store of scientific learning. But, whether high or low tech, the traditional venture capitalist thrives when the companies in which he invests have an advantage over potential competition in a defined segment of the market, often referred to as a "niche." The product or service is as differentiated as possible, not a "commodity." Exploitation of scientific and technological breakdowns has, historically, been a principal way (but not the only way) for emerging companies to differentiate themselves from their more mature and better-financed competitors.