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B School
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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
This relationship between fundraising and performance extends to the industry as a whole. When the industry’s performance is strong, investors pour more money into venture capital. However, when more capital is committed or invested realised returns suffer, investors eventually pull out. Thus, the industry has a self-correcting mechanism – a period of poor returns that leads to decreased inflows, which, in turn, leads to a recovery of returns. The amount of capital committed and invested in a particular vintage year and the previous year are predictive of the average return in that vintage year.

Thus, if numerous investors are thinking of ending their commitments to this asset class, as critics claim, it may be good news for VC investors. Historically, reduced capital inflows are associated with higher returns in the future.

There is a concern, however, that it is more difficult to take a company public than in the past, which would undermine one of the most important ways VCs exit or sell a company. In the 1990s, there were more than 100 VC–backed IPOs a year in all but one year. In the bear market of 2001 to 2003, however, this number dropped to below 50 a year. This is not unusual in a recession. However, VC–backed IPOs failed to bounce back in 2004 to 2007, staying low at slightly more than 50 a year despite the robust stock market and the large number of companies that received VC funding in previous years.

Some say there were so few IPOs partly because it was very costly for public companies to comply with the Sarbanes-Oxley legislation, and also because of the lack of attention from investment banks that were able to make more money from other activities. However, it is possible that these constraints have eased and that there will be more VC–backed IPOs in the future, which would boost returns to venture capital.

A rich source of r&d
Changes to the U.S. corporate research and development system also are likely to have a positive effect on the future of the VC industry. For most of the 20th century, corporate R&D in the United States was centralised and set up within companies as campus-like facilities that employed thousands of researchers, many of whom were free to pursue fundamental science with little direct commercial applicability. These include Bell Laboratories and IBM Central Research, whose researchers have won several Nobel Prizes.

But because of intense competition and disappointing commercial returns, U.S. corporations began to rethink the role of centralised research facilities. Firms started to reduce the size of these facilities in favor of divisional laboratories and “open innovation” – that is, alliances with and acquisitions of smaller firms – to meet their technology needs.

Thus, the demand for VC–backed companies is likely to drive the growth of the VC industry for years to come. In fact, the practice of growing companies for full or partial acquisition by larger firms has been going on for many years in the computer networking business.

Amir Moin           

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