Ok, now you understand how it all works — how venture capitalists get money, make money, and then give it back to their investors in turn. Why does that matter?
It matters because there are only two ways for a VC-backed startup to be a success for its investors: Go public or get bought. As the CEO of Puppet, I always said any company has four options: Go broke, go public, get bought, or stay private indefinitely. If you take VC money, that last option is off the table.
It’s worth saying again: You take VC, you are committing to getting bought, going public, or going broke.
Crucially, that means that investors must push you into one of those outcomes. The reason they deride private businesses that generate cash isn’t because they’re bad businesses, it’s because they’re structurally incapable of profiting off of them. Their system is limited to valuing sales or IPOs; nothing else can have value to them, because nothing else allows them to make money.
This means that if you’ve got a great company that’s taken some VC but is at real risk of settling into a mere twenty percent growth rate with a sight to profitability but only making, say, $30 million a year, they’re going to push you out of that comfort zone. They have to. They’ll ask you to raise a “growth” round so you can “really scale this thing”, or they’ll try to sell the company. If that doesn’t work, they’ll just fire you and put someone in place who will do it for them. It’s not because they’re evil, it’s because their contracts essentially require it. They can’t return the stock of a private company to their LPs, so what choice do they have?
Now that we understand how investor behavior is driven by how capital is returned to investors, let’s discuss what it means to the technology startup ecosystem as a whole. (There are VCs for things outside of tech, but the asset class was basically invented for technology, and that’s where it is centered.)
If you’re seeking funding for your technology company, you essentially have to promise that you can and will sell your company for an outsized return, or that you can and will take it public. In reality, almost no one invests with the expectation of a sale; they’re all betting on an IPO, recognizing that a sale is a good second option. It doesn’t matter if you can generate a ton of profit; they have no use for that. In fact, it might get awkward if you started distributing dividends.
This has two big consequences. The first, of course, is that companies that don’t have a realistic shot of going public can’t get venture capital. This is a striking constraint, given how much of our economy consists of small, profit-generating businesses that generate jobs and cash locally, whereas the ranks of public companies that distribute returns only to the investment class have been shrinking for decades. The story they’ll tell you is that only those really high-growth companies “need” VC money, but it’s much simpler than that: Their business model doesn’t work if your company doesn’t sell or go public.
Bank loans do ok at providing funding for low-risk actions by mature companies, and VC does well at funding high-risk companies with the chance to be huge, but there’s a huge gap in the middle that struggles to get any funding. (Both of these funding mechanisms in the US also suffer from being overwhelmingly biased toward only funding white men, but that’s a different essay.) Medium-risk companies often do need funding, but can’t get it, which in many cases means the businesses either don’t exist or end up much smaller than they could be.
The second major consequence is that a lot of companies are able to convince themselves, and thus investors, that they could get big enough to go public. Yes, this is sometimes true, but in so many cases it is instead a lie that both parties tell in order to get the funding done. If you love your company, and the only way to keep it alive is to promise to keep growing, you will. You understand the risks, but they’re better than just letting your company die.
In too many cases, this absolute demand for continued growth is exactly what kills companies. They never learn the operating discipline necessary to generate cash (which, in the end, actually still is king), and they get too big to sustain themselves. At some point, the lie gets out, they can’t get more funding, the fundamental unsoundness of their business model becomes clear, and the whole thing deflates.
When you hear a VC say you should focus more on growth than cash, what they’re saying is “You should worry more about my ability to return capital to my investors than your ability to still have a company in a few years.” It might be that growth is the right thing to invest in, but it isn’t automatically the right thing, and it’s at least fair to say that the investor is not a neutral party in this recommendation.
So now we see that so much of what we find poisonous in the world of venture capital is actually the result of how returns are distributed to investors. The growth-at-all-costs mentality, the huge amount of dead companies, pushing employees to work to the bone until you get an exit, and much more can be laid at the feet of this simple constraint.
I don’t know if there is an alternative model that will work in the world of high-risk tech startups, but I do know there are plenty of other investment models that are able to deliver returns without introducing this kind of dysfunction. Conglomerates like Berkshire Hathaway are able to own significant chunks — or even the entirety — of companies and deliver great via growth, dividends, and clever use of float. This provides them the flexibility to let their portfolio companies choose their own best means of returning capital to investors. Coincidentally, Berkshire Hathaway is the one non-VC-backed company in that list of six largest companies.
If our industry could develop a funding model that was as compelling to founders as is the current venture capital model, the dysfunctions that we’re experiencing would be reduced as businesses naturally gravitated to whichever fit them best.
Fundamentally, venture capital isn’t causing the dysfunction in the markets; the lack of alternatives to venture capital is.
Venture Capital Funding Essay
rodrigo | November 11, 2017
WritePass - Essay Writing - Dissertation Topics [TOC]
The determinants of Venture Capital Funding: Performance of US Venture Capital Firms against European VCs
Over the last decade, many researchers have praised the influence of Venture Capital (VC) as a key driver of entrepreneurism, start-ups, innovation and economic growth (Da Rin et al., 2006; Cumming, 2014). VC has long been studied and observed in the United States, it is for these positive reasons that the EU have outlined the development of VC as a major policy priority (EVCA, 2001). It is only within the last 20 years that the European Market has moved from being perceived as an “emerging market” in terms of VC, and that even by the start of the 21st Century, the aggregated investment volume was €12 billion which was less than 25% of the American investment volume at that time (Hege et al., 2003; EVCA, 2001). Due to the relatively recent development of VC in Europe, there is a large gap in the existing research as to the effectiveness and influences of VC in Europe. Certainly Popov & Roosenboom, (2013) bemoan the fact that the majority of existing research into venture capital typically focuses its attention on the United States. Thus, there is a real shortage of effective empirical studies into the behaviours and qualities of European VC. Jeng and Wells (2000) support this view, explaining that factors such as the contracting, organisation of VC firms, exit decisions, and “the peculiarities of Europe” are not fully understood, nor has the features that European markets share with American ones have not been made in strong detail. Thus, this dissertation will provide a comparative study into the American VCs and European VCs. This micro-level study will to address the gap in existing research of the rate of return for VC in the US and the EU, possible the most influential emerging markets for venture financing.
This research will look to examine the performance of US venture capital firms against European venture capital firms to identify whether a gap exists between the two groups and to determine whether European VCs ca improve the rates of return from total investment based on funding frequency and other variables. The main objectives of this dissertation are:
- To determine if there is a gap in the levels of performance amongst American VC and European VC paying particular attention to the type of exit and rate of return.
- To explore whether any gap could be the result of major differences in the contractual relationship between VCs and startups in these regions or from the use of key tools that assert an active role of VCs in the process of value creation.
- To identify any relevant policy determinants including regional tax, investment protection/treaty, Intellectual property rights, and financial regulation.
- To determine whether US VCs have better screening skills than European VCs and whether this produces a higher degree of turning initial investments and funding frequency into successful ventures.
Importance of the Study
This research looks to address the gap in the existing research into the emergence of VC in European markets, and looks to benchmark this against VCs in the United States. Researchers, data providers, and trade associations have all observed the notable gap in existing research into VC in Europe (Da Rin et al., 2006; Cumming, 2014). Trade associations have even pointed to this gap in understanding as a primary factor that causes them to hesitate with early-stage financing. This dissertation study will also be significant as it will look to provide a critical, microeconomic analysis of the main drivers and influence of successful VCs in America and observe these against VCs in Europe, exploring contractual features and firm characteristics to define and quantify the determinants of VC returns. This will look to address the gap in existing research in the European VC sector and provide a greater understanding of VCs in Europe.
Proposed Research Method
A combination of quantitate and qualitative research tools will be used to complete this study. Research data will be found using a range of sources, including the World Bank, the Organisation for Economic Co-operation and Developmen (OECD) and other key institutions with data on several policy factors. These data sources will provide information on an expansive range of portfolio organizations, key investments and valuations. Quantitative data analysis will be completed using the statistical package software SPSS. The statistical package software benefits the cleaning and transformation of the data. Following the completion of the data collection stage, the researcher will analyse the raw data and assemble the results into a data matrix. This data matrix with contain the details of the study with key information sorted into columns, variable and values. The data matrix will then be used for statistical calculations and used for the analysis of the results. This dataset will allows the researcher to study organisation’s performance in terms of Internal Rate of Return (IRR) of the investment amongst the initial investment to the final value of the firm. This study will also aim to quantify the influence of VCs on project profitability in Europe and compare this to the United states. A valuation-based measure of the rate of return will be used to examine the characteristics of European VCs against US VCs. independent variables to be studied will include age (the time elapsed since the VC raised the first fund), Regional (does the VC only invest in their own country), Companies (the number of companies in the VCs portfolio), Duration (the average investment duration in years), and, finally, the taxation policies of the US and Europe. The following equation will be used to calculate estimated values (V1) for the first stage valuation for all European organizations: Qi= V1i=I1i.
Here Qi represents the initial value for company, whereas i is the multiple of the initial investment. The average Qj ratio will be determined of all selected studies.
The research will also use the following hypotheses:
- Hypothesis 1: European VCs performance is positively correlated with the rate of return of the investment between the initial investment and the final valuation of the project/firm.
- Hypothesis 2: increased continuity of VCs engenders a stronger relationship which reduces barriers to financing and will increase returns.
- Hypothesis 3: European Venture-backed companies could benefit from the presence of alternative investments besides independent VCs.
Black, B. S., Gilson, R. J. (1998) ‘Venture capital and the structure of capital markets: banks versus stock markets, Journal of Financial Economics, 47, pp. 243-277.
Cumming, D. (2014) Public economics gone wild: Lessons from venture capital, International Review of Financial Analysis, 36, pp. 251-260.
Da Rin, M., Nicodano, G., Sembenelli, A. (2006) ‘Public Policy and the reaction of active venture capital markets’, in Journal of Public Economics, 90, pp. 1699-1723.
EVCA (2001) A Survey of Private Equity and Venture Capital in Europe, Yearbook 2001
Green, J. (2004) “Venture capital at a new crossroads”, Journal of Management Development, 23(10), pp. 972 – 976.
Hege, U., Palomino, F., Schwienbacher, A. (2003) Determinants of Venture Capital Performance: Europe and the United States, LSE Working Paper, 1, pp. 1-40.
Jeng, L. A., Wells, P. C. (2000) ‘The determinants of venture capital funding: evidence across countries’, Journal of Corporate Finance, 6, pp. 241-289.
Popov, A., Roosenboom, P. (2013) ‘Venture Capital and New Business Creation’, Journal of Banking & Finance, 37, pp. 4695-4710.
Tags: US Venture Capital Firms, Venture Capital Funding
Category: Articles & Advice