Venture Capital And Its Role In Modern Economy

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The last 50 years have been considered as the most innovative years in human life, driven by a new era of entrepreneurship. The millennial generation, motivated by risk-taking startups, wealth and innovation, have eternally shaped the world’s economy, with $254 billion invested globally in 18 000 startups in 2018. According to Nucleus Partners, “Start-up financing is not just about raising funds, it is a holistic process that involves proper business planning with thoughtful growth targets.” Nowadays, the exposures of entrepreneurs to risk are being supported by the mentorship of venture capitalists (VCs), a person or company that invests in a risky business, providing capital for start-ups or expansions. VC’s began to rise in the late 19th century when wealthy families (Vanderbilts, Morgans, Whitney’s and Rockefellers) hired professionals to invest in promising companies in order to receive high returns. Since then, the amount of VC funds has been growing continuously, with more than 107 firms in the United Kingdom, putting them at the center of debates. Indeed, many have criticized the concept: Piketty, a French economist known for his book, “The capital in the 21th century” (2013), denounces capitalists as the “inferior intellect”, uneducated individuals earning a large amount of capital through investments, which may lead the economy into a financial crisis. Why do VC’s exist and what is their role? Some say that VC’s have revolutionized and shaped today’s economy, but to what extent can that be proven? By being in control of the investor’s capital, and investing in such early-staged companies, VC fund enables life-changing, yet extremely risky companies and products to emerge and succeed.

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Deriving from the Latin phrase, “to venture”, meaning “to dare or to do or say something that may be considered audacious”, VC’s are one of the few investors willing to invest in companies that are in the early and risky stages of their growth. This allows entrepreneurs to create products of the future, such as Uber or Airbnb, two companies funded by VC’s.

In order to understand the importance of VC’s in our society, it is necessary to learn how they’re structured. A VC lifecycle is made out of three main phases: fundraising, investing and exiting. VC’s have to raise a significant amount of money from investors to be able to invest in a chosen portfolio of startups. When all the necessary funds have been raised, the stage of investing can begin. VC’s role become essential: having past experiences, bouncing back from investor to entrepreneur, and by having a broad network, investments are usually thriving. For example, Yale University has generated a 30% average annual return on its VC investment since 1973, making them the third richest school in the US. The last and most important stage consists of exiting the startup. In order for both the VC’s and investors to gain back capital, there has to be a liquidity event which can take different forms, such as a share repurchase, an acquisition or an initial public offering (IPO). In 2017, Snap. Inc successfully went public in March 2017 at a valuation of 25 billion dollars, being the highest valuation at exit since 1999. However, not all post-IPOs are successful. After its IPO in 2019, Uber has seen its stock prices fall to 20%. Nonetheless, VC’s existence is important as without their experience and knowledge, the process between startups and investors would be much more complex.

Furthermore, the structure of the VC fund as a Limited Partnerships, meaning that one partner takes full responsibility for a full control over the business (Cumming, Johan, 2014), shows the importance of a VC throughout the process. The VC (known as general partner (GP)) is the intermediate between the limited partner (LP) and the entrepreneur, and takes the role of manager, leaving the LP’s with no direct control over the investment decisions. Having enough experience, LP’s and entrepreneurs give their full trust to VC firms. These funds can be described by contracts that lead the stakeholders (Agmon & Sjogren, 2016): one contract is between the LP’s and the VC firms, where LP’s agree on a certain amount of capital given that will contribute to the investment fund. The second contract describes the GP’s payments. All GP’s receive a management fee which represents 1% to 2% of the funds they have raised and receive between 20% to 25% of the profits returned to the LP’s, called the carried interest. However, these past few years, other forms of funds have appeared, said to be more flexible, for both startups and LP’s. The evergreen fund is a fund with no end date, no limitation and only one management fee. Myers of Greybull Stewardship explains that “Every couple of years LPs have the ability to exit or to change their investment in the fund” (Fink, 2014). With the ability to control what they can invest, evergreen fund reduces the LP’s costs, which is an impressive gain for the investors. Furthermore, there is the corporation VC fund. In this case, the corporation is the LP, meaning that corporations directly invest their capital into startups. Corporations will seek for synergies to create value. Startups that are under the influence of these corporations can benefit access to market opportunities and partnerships with other strategic businesses, helping them to grow significantly fast. Therefore, having different types of VC fund structures enables investors and startups to have more flexibility and choices that best matches the good of their startup.

Investing in the early stage of a company is the main role of a VC. Depending on a startup’s stage, different amount of fund is needed to further expand. During an early stage (the seed-stage), companies need a small amount of capital to prove further credibility to VC’s (Metrick & Yasuda, 2006). However, few investors would be willing to invest at this relatively risky stage despite the high returns that can be earned. The firm has nothing but an idea. If the startup is successful, it’ll enter in the expansion stage, where companies need further funds to develop their products on the market. As the operation becomes less risky, more investors come into the picture, but returns are less impressive, and the VC’s role switches from a support role to a strategic role. By taking the risk to invest in such early stages, unicorns startup (companies that have a valuation of over $1 billion) such as Toutiao ($75 billion), Airbnb ($35 billion) or Grab ($14.3 billion) from all over the world have arisen and changed our daily lives. In 2014, The Wall Street Journal stated that VC’s were “Humanity’s Last Great Hope” for their ability to identify and nurture transformative technologies (Wall street journal). Thus, VC’s exist to help such high technological firms expand, and continuously change our daily lives to make it a better place.

Venture capitalists are the mentors throughout an entrepreneur’s life, guiding them towards risk, yet a successful end. Having confident entrepreneurs with interesting projects leads to powerful investment, economic growth and employment.

Entrepreneurs are said to be the drivers of growth. But would they be willing to take as much risks without any mentors by their side? The statement “Entrepreneurs are born, not made” has been challenged since the emergence of VC’s. By taking control of their startups, VC’s are mentoring entrepreneurs through every step of the process, helping them gain new perspectives and leadership skills. The job of a VC is a difficult task, full of risks, and demands a certain expertise in the middle of entrepreneurship. According to Buckminster Fuller, “Sometimes I only find out where I should be going by going somewhere, I don’t want to be”. Indeed, VC’s have at least once met the “Death Valley”, which is the difficulty of covering the negative cash flow in the early stages of a startup. Such a difficult task demands different traits: being a negotiator, an astute trader, being confident and skeptic, and thus explains why only 500 VC firms exist today in America. In addition to being a powerful teammate and leader, VC’s have the capacity to reduce information asymmetries. Separating ownership and control (Fama & Jensen, 1983) results in agency risk. Investors have little information about the product or company, yet as they are eagerly seeking for high returns, they have no choice but to give all their trust to these entrepreneurs. As a result, entrepreneurs tend to lie about how actually profitable their companies are, leading to moral hazard, a situation in which one party gets involved in a risky situation knowing that it is protected against the risk, while the other party will incur the cost. The emergence of VC’s has largely reduced these risks. Often compared to marriage counselors, VC’s have to maintain a solid relationship and communication between entrepreneurs and investors, making sure that as much information is given to investors. One of the important reasons that explains VC’s existence is because they help reduce asymmetries of information, giving more confidence to investors and helping entrepreneurs have a higher chance of success.

Today, with 582 million entrepreneurs in the world and with a generation of investors, VC’s have become a necessity to the economy. This all began in the 1980’s, with the decline of the “Fortune 500 companies”, when the American economy shifted. More than 4 million jobs were lost, whilst smaller companies (with fewer than 100 employees) added more than 16 million new jobs. Americans rapidly began to understand the importance of startups, explaining its unstoppable growth until today. In 2001, a study was made by Lerner and Kortum showing that in the United States (US), a dollar invested in venture capital created three times more patents than a dollar invested in research and development (R&D). Over the last 40 years, venture backed companies produced $3 trillion in annual revenues, 21% of US GDP and 11% of the private-sector jobs. In a short period of time, VC’s revolutionized the market. Due to their success in the US, VC’s rapidly expanded in Europe. Indeed, the United Kingdom is known as the European “early adopter” of startups, where the VC UK market has raised more than 54% of the European VC market (Dehesa, 2002). Indeed, following the 2008 recession in the UK, a change in the economic environment and structure of the industry had to be imposed. Today, “If you can get your company working in the UK,” Duffy explains, “you have some idea that it might be transferable elsewhere.” With more than 2 million people employed in the UK by venture-backed companies, VC’s have become a necessity to the economy. Without their existence, there would be less employment and economic growth.

Despite the importance of VC funds in today’s world, they have limits and alternatives that have questioned their position in the current industry.

In the beginning of 2000’s, a huge economic crisis, the Dotcom Bubble (or internet bubble), negatively impacted the US. During the 1990s, with a sudden rise in internet and technologies, VC’s poured thousands of capitals into internet-based startups, and the NASDAQ stocks kept on rising. In 1999, it was stated that a new millionaire was created every 60 seconds in the Silicon Valley. However, the dot-com dream rapidly came to an end when the NASDAQ stock index crashed from 5,000 to 2,000, and the IPO’s lead to no profitability. Today, there is a debate on whether or not a new bubble is about to burst. Indeed, in 2017, the famous businessman Fred Wilson said, “All markets have boom and bust cycles, and I think venture capital has even more exaggerated boom and bust cycles”. In 2018, $160 billions of capital was invested in startups, yet due to a significant proportion of unprofitable companies on the market, a second bubble could burst. According to Goldman Sachs, only 24% of IPO’s in 2019 will earn a positive net income, and according to the ex-CEO of NASDAQ Greifeld “it reminded me back of the dot-com era, when you had companies going public that had no known path to profitability” (Burszytynsky, 2019). As seen in the graph below, in 2018 there has been a decrease in the overall number of closed deals, which is mainly due to a decrease of companies making it to series A funding. However, capital invested in companies has risen from $33 billions of dollars in 2014 to $73 billions of dollars in 2018, showing that despite a decrease in closed deals, VC funding’s are of great importance to our society.

With a society that is constantly progressing, technologies have taken an important role and seem to be VC’s main targets. The question here is, to who should non-technological firms raise funds to? and to who should startups go to when only wanting to raise a small amount of capital? By not being compatible to all sorts of startups, the existence of alternative forms is a necessity. Crowdfunding consists of raising a small amount of money from different individuals through the internet. Today’s world is progressing and these modern platforms, enabling to bypass the traditional routes of VC’s, are becoming popular. With more than 34 billion dollars raised, and 270 000 jobs created, crowdfunding is becoming ideal for firms that want to raise small amounts of capital, something unimaginable for VC’s. A second alternative are angel investors, which are generally previous successful entrepreneurs, that invests their own fund in early-stage startup, in exchange for ownership equity. Unlike VC’s, angel investors won’t take up the responsibility of managing startups and aren’t willing to invest more than 1 million pound in the company. This is an ideal funding form for entrepreneurs that refuse to lose equity and decision-making power. In addition, angel investors aren’t only interested in high-tech startups, enabling basic and non-technological startups to raise funds. Finally, bank loans have been widely used by entrepreneurs as they are a much more flexible option than traditional VC funds. A bank loan is an amount of money borrowed for a set period within an agreed repayment schedule. Thus, by repaying interests, entrepreneurs are keeping equity in their company and all their leadership. These alternatives to VC fund have shown that with progression and time, startups are changing their ways of functioning, putting at risk traditional forms such as VC funds.

In conclusion, the existence of VC’s is fundamental to our society. Having an impressive knowledge in the middle of entrepreneurship, startups identified by VC’s have largely contributed to the evolution of our society: in 2018, more than 95 million individuals used Uber every month, and there were more than 4.5 million Airbnb properties across the world. In addition, VC’s existence has helped both entrepreneurs and investors being more confident, thus increasing investments, leading to employment and economic growth. However, they have been largely criticized by individuals feeling threatened by the burst of a second bubble, which could lead to a financial crisis. Nonetheless, it is important to question ourselves about VC’s place in the future. According to Mildenberger “In the next 10 years, venture capital will become easier and more accessible to a much broader segment of the population”. However, one may believe that banks will become even more fearful, which will lead to an increase in the numbers of alternative funds and will threaten the existence of VC’s that may be replaced in the near future. 

16 August 2021

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