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A successful venture: The past, present, and future of Venture Capital
The Venture Capital model is not broken, nor does it need to radically change. In fact, its future looks quite bright, with demand for VC-backed companies likely to rise in future.
Issue Date - 02/02/2012
Venture capital (VC) has fueled many of the most successful start-ups of the last 30 years. Microsoft, Apple, and Google – three of the biggest companies in the United States – were once backed by VC firms. Many well-known and highly valuable companies such as eBay, Amazon, Yahoo, and Starbucks likewise started out with funding from venture capitalists. The VC model of financing young and untested companies with high growth potential has been so successful, it has been replicated all over the world.

However, a recent study me Steven N. Kaplan and Josh Lerner of Harvard Business School, shows that the U.S. VC industry is not broken; it is simply going through the expected ups and downs of a competitive market. In the study titled It Ain’t Broke: The Past, Present, and Future of Venture Capital, we show the amount of money committed by investors to this asset class as well as the amount invested by VC firms in the last 30 years has been remarkably constant. In addition, average returns to VC funds do not appear to be unusually low or high relative to stock market returns.

In fact, based on the historic relationship between commitments to VC funds and subsequent performance, the historically low level of funds committed in 2009 and 2010 suggest that the returns to investing in these funds will be relatively strong. Moreover, the declining importance of central corporate R&D facilities in favor of buying small firms to acquire the latest technologies is another reason to be optimistic about the future of the VC industry.

The efficient man in the middle
Entrepreneurs have good ideas but sometimes do not have the money to set them in motion. Investors, on the other hand, have the resources but may lack good ideas. In this case, VC firms step in to bring entrepreneurs and investors together. They do this in three ways.

First, VCs spend a lot of time and effort screening, evaluating, and selecting investment opportunities. It is an intensive and disciplined process that typically takes place over several months. VCs scrutinise the attractiveness and risks of the external environment – market size, competition, and potential for customer adoption; the feasibility of the strategy and technology; the quality of the management team et al.

Second, VCs efficiently design contracts in such a way that if the entrepreneur is performing well, he or she is well compensated. If the company is running smoothly, VCs do not have to get involved in the company. However, if the company performs poorly, the contracts stipulate that VCs can take full control. As performance improves, the entrepreneur obtains more control rights. It also is common for VCs to include provisions that would make it very costly for the entrepreneur to leave suddenly after investors have already made a significant investment in the company.

Third, VCs play an important role in improving the outcomes of their portfolio companies, mainly by monitoring management and giving valuable advice. This often means replacing the entrepreneur when it becomes clear that he or she is not up to the task of growing the company. Moreover, VCs assist the entrepreneur by helping formulate strategies, hire other executives, and by introducing the entrepreneur to other business partners.

Although only a tiny fraction of new businesses (about one-sixth of one percent) receive VC funding in the United States each year, a very large percentage of small businesses that do well enough to go public are backed by VCs. Since 1999, between 50% and 60% of IPOs have been VC-backed firms. In other words, it is highly unlikely that a company that did not receive VC funding will end up going public.

Is the vc model broken?
I am skeptical of claims that the VC model is broken, that there is too much money in the industry, or that it needs to radically change because of poor performance and opportunities. Empirical evidence suggests otherwise.

Compared to the total value of the stock market, the amount of money committed to VC funds has been remarkably stable over the last 30 years. Since the 1980s, VC commitments have never gone below 0.05% of the total stock market value or above 0.23%, except during the 1999 to 2001 internet technology boom. This figure has been slightly above the historical average since 2002. Similarly, VC investments have never exceeded 0.20% of the value of the stock market. Since 2002, investments have been slightly below the historic average.

The returns to investing in venture capital also have neither been unusually high nor low relative to investing in the stock market. Previous analysis by me and Massachusetts Institute of Technology professor Antoinette Schoar on the performance of funds raised prior to 1997 shows that returns net of fees paid to VCs are competitive compared to stock market returns, and exceed stock market performance gross of fees.

My assessment of VC funds invested from 2001 to 2005 likewise indicates that the returns from these vintages were roughly equal to that of the stock market. Although there are some limitations to estimating the performance of more recent funds, our estimates may understate VC fund performance to the extent that bad investments have been written down while better investments have not yet been written up in value.

There also is evidence of persistent performance. If a VC firm earns a good return on one fund, it tends to perform well on subsequent funds, especially if the fund belongs to the top one-third in terms of outperforming the stock market. This is substantially different from findings in other asset classes. Previous research on mutual funds, for instance, finds no evidence of persistence among top performers.

Fund size, however, is the enemy of persistence. VCs who have funds with good returns tend to get bigger while those with funds that earn poor returns tend to get smaller or have difficulty raising additional money. But a recent study finds that at some point – about $200 million – returns stop increasing with size, then begin to decline when the size of the fund is greater than $500 million.

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