By Rebecca Kauffman
Mark Hessen, president of the National Venture Capital Association, called the following article a “Must-read” at a recent venture conference: One of the great ironies of the emerging company world is that venture capitalists themselves must raise money. The venture investor who just said no to your deal once sat across the table from another guy (a prospective limited partner), who said “no” to him. More than one fundraising CEO has smiled at that thought over the years.
So what does it take to raise a venture fund? This article explores that issue from a historical perspective, both nationally and with particular reference to those regional venture funds launched over the last three decades still active today in the life sciences sector. It also looks forward, to prospects for first time funds in view of current market conditions.
A little US history
The U.S. venture capital industry originated in the technology boom of the post WWII years. Many of the earliest funds were high-risk, high-return investment partnerships for wealthy individuals and families with such recognizable names as Whitney and Rockefeller.
The first modern venture fund was formed in 1946, when Gen. Georges Doriot, a Harvard Business School professor, co-founded American Research and Development Corp. (ARD). Doriot formed ARD as a public company on the premise that a “venture capital company” could raise money to fund new technologies by selling its own stock to public market investors.
More than half of ARD’s shares were owned by insurers and educational institutions, including MIT and the John Hancock Mutual Life Insurance Co. With $5 million in hand, ARD made a series of high-risk investments in emerging companies. Although it struggled for at least a decade, ARD ultimately delivered solid returns to investors, based largely on the success of two key technology deals. Doroit’s impact on the nascent venture capital industry wasn’t limited to ARD; in his continued role with HBS, he influenced the next generation of venture capitalists and entrepreneurs. As a result, he is widely regarded as the “father of venture capital.”
The passage of the Small Business Investment Act of 1958 further spurred the development of the venture capital industry. Concerned with the growing technological advancement of the Soviet Union, the federal government created the Small Business Investment Co. (SBIC) program within the U.S. Small Business Administration (SBA).
The legislation allowed SBA-licensed SBICs to borrow money from the federal government at favorable interest rates to leverage their private capital three-to-one and later, four-to-one, so $1 million became $4 million courtesy of the U.S. government. A number of non-SBIC funds also formed, not subject to certain restrictions (e.g., size) imposed by the SBIC program. Collectively, these funds were among the first professionally managed venture funds.
Unlike ARD, most of these funds were not public companies. Instead, they were private partnerships, which raised investment capital from wealthy individuals and their families, as well as public or private business entities controlling large sums of capital, such as banks and other financial institutions, insurance companies, pension funds and large corporations. These investors would typically allocate a small percentage of the capital under their control to relatively high-risk venture capital, as a way of diversifying their holdings.
Under the preferred structure, each investor would serve as a limited partner in the fund by committing a certain amount of capital. A fund would have anywhere from just a few to as many as 100 limited partners. The fund would then be invested by the professional fund manager, also known as the general partner.
Each fund had a given “lifetime” (typically 5-10 years) during which it was expected that all investments would be made and returns generated. Venture-style returns (historically, averaging 15-25 percent but sometimes far greater) were typically generated by public offerings or acquisitions, which would permit investors to liquidate their holdings. Funds that produced superior returns would find it relatively easy to raise their next fund from the same or new limited partners.
Sometimes, fundraising for the next fund would begin before profits from the first fund (or even committed capital) had been returned. In return for raising, investing and managing the funds, the general partner would collect a management fee (typically 2 percent) and, once the invested capital was returned to the limited partners, a share of the profits—together with the limited partners.
The funds were typically used to invest in new and rapidly growing private companies, in which the venture fund would take stock. In the late 1960’s and early 70’s, disproportionate number were located in Silicon Valley, where the success of Fairchild Semiconductor in consumer electronics and commercial computers post WWII spurred remarkable entrepreneurial efforts.
More than sixty semiconductor companies were formed in the area from 1961-1972, including Intel, National Semiconductor and Advanced Micro Devices, almost all by former Fairchild engineers and managers.
The rapid growth coincided with the emergence of the local venture industry, including the launch of the now legendary Kleiner, Perkins, Caulfield and Byers in 1972 and the various other funds that would locate on Sand Hill Road, now synonymous with the venture industry. For a time, venture capital was all about technology investing.
End of Part One. Tomorrow, “Shadow over the Industry.”
A full version of this article and Rebecca Kauffman’s other articles for TechJournal South are archived at: http://techjournalsouth.com/news/channel.html?channel_id=93
Southeast Venture Conference, February 29 – March 1, 2012 at the Ritz Carlton in Tysons Corner, VA – Where Smart Money Meets Smart People.
www.seventure.org
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