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.
How Venture Capital Works
The popular mythology surrounding the U.S. venture-capital industry derives from a previous era. Venture capitalists who nurtured the computer industry in its infancy were legendary both for their risk-taking and for their hands-on operating experience. But today things are different, and separating the myths from the realities is crucial to understanding this important piece of the U.S. economy.
Today’s venture capitalists are more like conservative bankers than the risk-takers of days past. They have carved out a specialized niche in the capital markets, filling a void that other institutions cannot serve. They are the linchpins in an efficient system for meeting the needs of institutional investors looking for high returns, of entrepreneurs seeking funding, and of investment bankers looking for companies to sell.
Venture capitalists must earn a consistently superior return on investments in inherently risky businesses. The myth is that they do so by investing in good ideas and good plans. In reality, they invest in good industries—that is, industries that are more competitively forgiving than the market as a whole. And they structure their deals in a way that minimizes their risk and maximizes their returns.
Although many entrepreneurs expect venture capitalists to provide them with sage guidance as well as capital, that expectation is unrealistic. Given a typical portfolio of 10 companies and a 2,000-hour work year, a venture capital partner spends on average less than two hours per week on any given company.
In addition to analyzing the current venture-capital system, the author offers practical advice to entrepreneurs thinking about venture funding.