They are the gatekeepers to the entrepreneurial economy -- the money guys with the knack for spotting a hot idea or a talented executive team.
Many people know they provide the seed money to promising young companies. What is less well known is that they also provide the wisdom of experience to the young chief executive, the imprimatur that opens the door to credit from suppliers and bankers, the connection to those all-important first customers. Starting a business has always been a who-you-know game, and the trump card is a three-year commitment from a rich and well-connected uncle or a prominent venture capitalist.
Although they act as if it's their own money they're playing with, mostly venture capitalists are an intermediary for other people's money. Not just any other people -- rich and sophisticated investors, pension funds, college endowments, the Saudi royal family. The money is bundled into separate funds, not unlike mutual funds, that invest in a number of companies, usually in exchange for a controlling share of each. When the last of the companies finally is sold, is taken public or closes its doors, the fund is retired and each investor gets his share of the pot -- minus, of course, the guaranteed fees and percentage bonus owed to the venture capitalists for managing the whole thing.
As a rule of thumb, of every 10 companies backed by venture funds, five wind up as dogs and three might be successful enough to pay back all the money invested plus a modest annual return. It is the two big hits -- the ones that return $20 for every $1 invested -- by which venture capitalists earn their money and their reputations.
And during the bubble, it was very big money. At the height, in the middle of 2000, venture firms as a whole could boast a 12-month increase in the value of their funds of 143 percent, according to data collected by Thomson Venture Economics and the National Venture Capital Association. Even now, after the bubble has burst and many of the promising young companies have gone bust, the winners turned out to be such big winners that the average annualized five-year return for venture funds is still 35 percent.
With those kinds of returns, it's no surprise that venture capital funds began to attract lots of wannabe investors. In 1995, the year Netscape Communications Corp. went public, venture firms invested $7.7 billion in promising companies. By 1999, that had grown to $55.5 billion. The next year it was $107.3 billion. That's more money in one year than the gross national income of Singapore or Venezuela.
Most now agree that it was too much money chasing too few good investments that created the boom and the bust -- and perhaps no pot of money was more important to that dynamic than venture capital.
Venture capitalists did little to warn investors that their excess enthusiasm was likely to be self-defeating. In fact, they encouraged more investments with speeches on the limitless possibilities of the Internet and the need for companies to quickly bulk up and achieve critical mass.
But having amassed so much money, the venture capitalists found themselves in a box. Either they would lower the standards by which they evaluated companies or business plans, just to put all of the money to work, or they could leave a significant amount of the money uninvested, knowing that it would pull down their sky-high rates of return and make it harder to attract new investors in the future. The evidence suggests that many venture capitalists convinced themselves that there were still plenty of good opportunities out there.
Much of the early action revolved around the Internet and centered in the financial corridor connecting San Francisco, Palo Alto and Silicon Valley. But in time other cities attracted their own venture capitalists to support their own technology segments, including Washington, which trails Boston, New York and Los Angeles.
Until recently, most of the money made by venture capitalists was reinvested in venture funds, creating a virtuous circle in which success fed success. But with the average venture fund having suffered a 24 percent loss so far this year, the circle has turned vicious. Money is slowly flowing out of the sector, with new investments by funds running at the annual rate of about $21 billion. Most of that money is going not to promising new start-ups but to keep alive the best of a bad lot of old investments in the hopes of turning things around.
-- Steven Pearlstein