What is Venture Capital?

By Daniel DeWolf

Most of us go through our lives down a certain path. We grow up in our house or apartment; we go to school; we get a job; and eventually we grow up (one way or another) and live out our lives: sometimes happily, sometimes not so happily, and most times a little bit of both. In the course of this journey, many of us dream about starting something new, such as a new business based on a new concept or new paradigm. For many of us it is just a daydream. But for some, it is a call to action. Time and time again, an individual figures out a new way to look at things. Then from a scrap of an idea, and against great odds, this individual begins to build a new business. This creation of a business from the embryo of a concept is the genius of the entrepreneur. Instead of staying on the linear curve of what has been and what appears inevitable, a person jumps off the curve and ventures onto a new tangent. More often than not, that tangent leads to a dead end. But when it is successful, the financial rewards to the creator in our capitalist society are beyond most of our wildest dreams. In the crass terms of our capitalist society, the successful entrepreneur is able to turn a concept into cash.

The engine that drives this process is the capital invested in these new businesses. The term generally used for this type of capital is called venture capital, although a more apt name would be adventure capital. Each new idea turned into a business is an adventure and takes on a life of its own. More importantly, the capital invested in these new businesses help to create jobs, build dynamic companies, and fuel the growth of our economy.

Although many people believe that venture capital is a recent phenomenon, venture investing has likely primed new businesses in every culture that has a merchant class. For example, in Roman society, Marcus Licinius Crassus may have been the leading private investor of his times. During the reign of Julius Caesar, he was reputed to be the richest man in Rome. At that time, many of the buildings built in Rome were constructed of wood. Not surprisingly, these wooden buildings were susceptible to fire. Rome did not have a public fire department. In order to maximize his leverage in acquiring investment property, Crassus created his own fire department. Then, when a building caught fire, Crassus would send over his private fire department and offer to put out the blaze and, of course, offer to purchase the property at a steep discount. But Crassus's plan went one step further, bordering on true genius. If the owner refused, Crassus and his firefighters would simply leave without dousing the flames. At that point, the discount really became steep. Crassus was probably not only one of the first venture capitalists, but also one of the first vulture capitalists.

With the advent of the industrial revolution in the West, banks became a leading source of financing for business enterprises. Banks, however, generally loan money against assets. Often, new enterprises lack sufficient hard assets to pledge as security or are just too risky to qualify for typical commercial bank financing. Such new ventures usually require "risk capital," which generally takes the form of an equity investment. In the 19th and early part of the 20th centuries, the providers of such risk capital were usually wealthy individuals. Over the last century, however, merchant bankers and then venture capitalists emerged as significant providers of the risk capital needed for new investments.

In the United States after World War II, a new group emerged to finance these ventures. The new group is the professionally managed venture capital funds. These funds are set up solely to invest in new enterprises. This group is largely responsible for the explosive growth of new enterprises in America. 

Today in the United States, new businesses are funded by a combination of wealthy individuals (often called angel investors), merchant banks, venture money from large, legacy corporations, and professionally managed, private venture capital funds. The driving force in this process and the opinion leaders in this arena are the professionally managed, private venture funds. Typically, in the United States, the most successful new enterprises will, at some point in their economic cycles, receive funding from a venture capital firm.

Venture Capital as we know it today in the United States is truly a phenomenon of the post World War II economy. Arguably, the first modern venture capital firm in the United States was established in 1946 by General George Doriot, then a Harvard Business School professor. Doriot started a company called American Research and Development (ARD). ARD's goal was to finance commercial application of technologies that were developed during World War II. ARD's biggest success was its investment in Digital Equipment Company (DEC). In 1957, ARD invested $70,000 for a 77% stake in DEC. Over the next 14 years, the value of ARD's investment increased to $355 million.[1] Thus, began the concept of hitting a "home run" in venture investing. The year 1957 was also the year that a fellow named Arthur Rock, then an investment banker at Hayden, Stone & Co. in New York City, traveled to California to look at investing in a silicon chip company. Rock's efforts eventually led to the funding of Fairchild Semiconductor and the beginning of the rapid growth of the Silicon Valley economy. Rock subsequently moved to California and formed two of the earliest venture capital funds based in California. His investments in such leading companies as Intel, Telethons, and Apple are testament to his influence. There is little doubt today that the venture funds play a major part in driving the economy of the United States.

It is critically important for the entrepreneur to fully understand the nature of the venture capital business. Unless an entrepreneur is able to fund the enterprise by himself or herself, learning to work with the venture capitalists is imperative to the success of his or her business. What the venture capitalist is looking for is the next new big thing. The venture capitalist's job is to look around the corner and place big bets on potential big winners. What the entrepreneur must do is position his or her company in such a way, that the venture capitalist is willing to make that big bet on the entrepreneur's business. Together, the founder's ideas as fueled by the dollars of the venture capitalist will enable a new business to take on a life of its own; and hopefully such "adventure" will prove hugely successful and financially rewarding.

[1] Gompers, Paul. "A Note on the Venture Capital Industry".  FIBS 7.12.01