Industry Overview: Venture Capital

Posted by The Editors on December 3, 2012

The venture capital industry is a major shaker in the U.S. economy, funding companies developing technological and service innovations long before they become mainstream. After suffering a slowdown in recent years, many venture capital firms have changed their strategies and are investing in more late-stage companies, giving them less risk. As investors cozy up again to initial public offerings (IPOs), so have VCs with venture-backed stock launches reaching 11 in one month during the first half of 2007. That's the highest level since 2004. In the second quarter of 2007, more than $7 billion of venture capital was poured into nearly 980 deals. Evidence also suggests that venture-backed firms are better performers: According to a National Venture Capital Association's 2006 study, companies that had received VC financing between 1970 and 2003 accounted for 10.1 million jobs and $1.8 trillion in revenue in 2003, representing approximately 9.4% of total U.S. jobs and revenue. These companies registered a net gain of 6.5 percent in jobs and an 11.6 percent increase in revenue between 2000 and 2003, while nationally employment fell 2.3 percent and revenues rose 6.5 percent in the same period. These are impressive results for what insiders describe as a "cottage" industry.

Underneath their moneyed mystique, venture capitalists are essentially glorified middlemen, and their modus operandi is easily explained. In a nutshell, a VC firm acts as a broker for institutional or "limited partner" investors such as pension funds, universities, and high-net-worth individuals, all of whom pay annual management fees to have their money invested in high-risk, high-potential-yield start-up companies.

After amassing a certain sum from the limited partner investors-usually between $25 million and $1 billion-the VC firm parcels out the fund to a portfolio of private companies at various stages of maturity, from fledgling to much more established. The company, in turn, hands over an equity stake in its business. In other words, the VC industry is predicated on a simple swap of the VC's financing for an ownership stake in the company's success, often (but by no means always) before the company has begun generating revenues. VC funding has nourished some of corporate America's greatest success stories when they were still baby businesses-FedEx, Intel, Sun Microsystems, and Apple, to name a few.

Since the VC firm has a vested interest in its start-ups' success, partners will generally sit on several boards of directors, offering advice and additional resources to help businesses grow. In the event that one of its startups merges with or is bought out by a larger company or goes public, any windfall is divvied up between the company, the VC firm, and the limited partner investors. Typically, the VC firm distributes 70 to 80 percent of the return on its investments to the various limited partners and keeps the rest for itself.

Bigger Is Better
The field is undergoing dramatic change. VC funds are getting bigger with two of the largest funds in history raised last year-Oak Investment Partners and New Enterprise Associates both broke the $2.5 billion mark. As a result, the stereotype of a VC fund coming to the rescue of some guy working out of his basement is a bit dated. These funds are investing more in established companies that represent less risk, and as some funds get bigger, they are beginning to squeeze out some of the smaller players in the market. But there are still opportunities for smart smaller VCs with good management teams who can spot opportunity. Some even argue that the smaller firms are more nimble and able to react to opportunity more quickly.

More Money to More Experienced Companies
Forget the garage-based startup. These big VC funds are ready to fork over big bucks (the median deal size in Q2 2007 was $8 million) to more established companies that are showing promise. Still, deals are up across all phases: Early-stage deals accounted for 36 percent of overall deal flow with 254 financings in the second quarter of 2007. That's up 17 percent from the same period in 2006. Later-stage financings made up 41 percent of the total, with 253 financings, the largest number of deals in more than six years. Second rounds accounted for 23 percent with 160 deals, the highest total since 2002.

Going Global? Maybe Yes. Maybe No.
While globalization is a buzzword in almost every sector of business, it's not so much so for VC firms. A 2007 report by Deloitte finds that, while some VC firms are thinking about crossing U.S. borders with their cash, fewer are actually doing it. They're finding adequate deal flow in the U.S., first of all. Plus, concerns about the costs and risks of doing business overseas-from costs of quality control and compliance with local laws, to issues surrounding protection of intellectual property under foreign laws-are a deterrent to shelling out international bucks. Among those markets that do get mild interest are China and India, particularly among smaller firms.

The venture capital world is made up of only a few hundred small partnership firms, usually employing between two and 40 people. These firms include the famous players-Kleiner Perkins Caufield & Byers, the Mayfield Fund, Bessemer Venture Partners-and many others. At first glance, these firms appear to be remarkably similar. They have few employees, lots of money to invest in entrepreneurial ventures, and they want to be part of the next phenomenally successful startup. Though the firms compete aggressively for deals, they also often combine into syndicates and invest in favored startups as teams.

Despite these shared characteristics, each firm has adopted its own approach to succeeding in the competitive and risky world of start-up financing. Firms differ in fund size, regional focus, industry focus, and stage of investing.

Although some firms specialize in low-tech investments, in recent years most VC firms have focused on technology-intensive fields such as software, biotechnology, and telecommunications, forgoing traditional investment areas such as manufacturing. Other hot industries include alternative energy, environmentally sensitive technology, and nanotechnology.

Divisions of large corporations, affiliates of investment banks, buyout firms, venture leasing companies, small-business investment companies, and other wealthy private investors also evaluate, fund, work with, and sell entrepreneurial organizations looking for capital. During the bubble years, an increasing number of nontraditional venture investors joined the start-up funding wagon, though some, hurt by poor returns, have reduced their commitments or gotten out of the business entirely.

Finding a job in VC isn't hopeless, but it will be hard. Firms are selective, and finding a job requires good luck and networking. One way to gain access to this industry is to do something great that is visible to people in this industry. So, being a rising young star at a biotech company or a product manager at a hot electronics company can get you on the VC radar. Operating experience at a technology company is a must in today's environment.

To make contacts, work your network. Find out who knows someone in the field and work on getting introductions. Go to VC fairs and make contacts with representatives of those companies. If you're hell-bent on a career in VC, don't give up. "If you strategize, are smart about looking for the opportunities, there will be some amount of opportunity for you to get in there," says an insider. Be strategic and persistent to get the doors to open for you.

Helping Build Firms
The greatest feeling for a venture capitalist is to see a firm that he or she has backed for years complete a successful IPO or grow into a thriving company. Not only does this confirm that you backed the right horse; it is also exciting to be around a startup when it takes off. VCs get to observe and participate in the growth of startups, with the excitement of getting the first customers, making its first profit, finding smarter ways to operate. It's a job where you get to the see the results of your efforts firsthand.

Bird's-Eye View
Since you don't have to deal with the operational details of running a business and since you are constantly evaluating new business proposals in a given industry, you really get a broad view of how an industry is changing and developing. You're not running one business-you're evaluating big-picture trends and spending money based on those market conditions. As one insider says, "You come out of business school thinking that running a business will be your main function in the business world. In venture capital, that's not the case."

Though the income can be more deferred than in other industries, it's pretty darned good. One insider says dryly, "It might take a few years before a venture capitalist gets wealthy." Successful venture capitalists can make huge amounts of money with less risk, and less chance of burnout, than entrepreneurs can. As the firms-and deals-get bigger, there's more money at stake, but also more potential to become wealthy within a shorter period of time.

Necessary Evils
It's hard to find a venture capitalist who doesn't firmly believe that he has "added loads of value" to entrepreneurial startups and to the world at large. But it's relatively hard to find a true entrepreneur who doesn't look at venture capital with some significant reservation, if not worse. Starting and funding companies is a high-stakes business. Venture capitalists are often criticized for pushing companies too hard to grow too fast and go public at the earliest possible date. It's not uncommon for them to step on toes and use their ownership stake to force a company to make controversial moves.

Not Every Idea Flies
VCs have a real financial stake in their business. And among the many start-up successes, there are always going to be failures. "People are less aware of it in the good times," says one insider, "but losses are a reality of this business. There are painful stories of layoffs and dreams that didn't work out. They're the ones that keep you up at night." This is a big part of the reason why more VCs are focusing on more well-established companies. However, the risk is still very real.

A Different Kind of Operator
As a venture capitalist, you're advising companies, but you're not operating them. Some people may prefer the hands-on work that goes on within an organization. This may be tough for people with operating backgrounds, who like to get in there, roll up their sleeves, and get to work. "People with operating backgrounds may not be satisfied in the role. They may miss working on products and having an impact. You're not in there running the company on a day-to-day basis," says an insider. "If you like to have that impact, it might not be as satisfying [to go into venture capital]." It's an interesting quandary for VC associates, because you'll need that background to break in, but you usually won't be able to apply it.

Staffing needs and titles vary greatly from one venture capital firm to the next. Many funds consist solely of partners and support staff. Others hire a limited number of undergraduates and MBAs as analysts and associates with the expectation that most will return to get their business degrees or join startups within a few years. (Keep in mind that while the terms "analyst" and "associate" usually refer to undergrads and MBAs or experienced hires, respectively, at some firms the titles are reversed.) Even at the lowest professional levels, compensation is tied to the performance of the fund. But because of built-in fund-management fees, no one ever starves at a venture capital firm-and as a rule, venture capitalists do very well for themselves. Top-tier partners at major funds are worth many millions of dollars. Lower-level professional staff and junior partners can expect total compensation exceeding (often vastly exceeding) $250,000 per year. Compensation at corporate venture funds is lower.

General Partner
These are the people with their names on the door. General partners raise the money for the fund and make the final decisions on which companies to invest in. General partners, the professional members of a venture capital firm, are usually required to contribute a small amount of their own money to their fund. They manage the fund's investments and generally take a 20 to 30 percent cut of the carry from the fund. General partners are expected to provide a wealth of business advice and industry contacts to the entrepreneurs they back. They often sit on the boards of many companies and are deeply involved in decisions about exit strategies-that is, when to cash out by taking the company public or selling it. Salary range: up to $500,000, plus the potential of millions in profits.

Junior Partner
Junior partners are just that: junior versions of the general partners. Usually, junior partnerships are viewed as training for general partnerships, and junior partners perform similar duties albeit on a reduced scale. Also reduced is their personal stake in the fund itself. Salary range: $206,000 to $270,000, plus a limited amount of carry, or percentage of profits.

VP or Associate
Some firms hire MBAs or people with business experience (usually in leveraged buyouts or investment banking) as vice presidents or associates. Associates screen business plans, make cold calls on prospective investments, and on occasion make on-site visits to portfolio companies. At this level, compensation, while still tied to the overall performance of the fund, can take the form of a flat bonus rather than a percentage of the fund. Salary range: $177,000 to $267,000, including bonus; VPs earn at the higher end.

Most venture capitalists have advanced degrees. However, a very few venture capital funds-generally those that are more established or are later-stage investors-hire undergraduates as analysts. Analysts screen business plans before passing them on to senior staff and do due diligence, or research, on promising industries and entrepreneurs. A background in finance and some outstanding college internship or business experience are musts, but venture capitalists also stress the interpersonal and networking skills that are essential to anyone working in VC. The typical stay for an analyst at a VC firm is three years, after which most get an MBA, work for a portfolio company, or move over to another VC firm. Salary range: $100,000 up to $120,000, plus bonus.

As mentioned earlier, this is not the easiest industry to get into. VCs don't recruit on campus and they don't put out ads in the newspaper or online. As a rule, you have to have a top school and relevant industry experience on your resume to get a shot at a coveted spot at a VC firm. Even then, you'll have a lot of competition. Here are a few things you can do to improve your chances:

  • A lot of the work at a venture capital firm involves gathering information about companies and industries. Show off your research abilities-at a minimum, know the VC world's terrain like the back of your hand, and nail the characteristics that distinguish the firm with which you are talking. You should also have a compelling story about why you want to work there.
  • Since VC firms don't hire many people on a full-time basis, you might try to get your foot in the door by doing a project for one of them. Alternatively, you might use a class project as a pretext to get an interview.
  • The best way to get into a VC firm may be to have a meaningful experience in a specific industry. Insiders tell us that people at middle or senior levels in high technology firms, usually with engineering backgrounds, are the most attractive candidates.
  • Since VC involves a lot of long-term projects with not much close supervision, you need to impress upon your interviewer that you are a very independent self-starter.
  • Being liked can be a big factor in getting a job at a VC firm. To save yourself the trouble of having to fake it, make sure you choose firms that are genuinely interesting to you. Chances are, you'll get along better with people with similar interests. Having a passion for whatever the firm's focus is will come across in an interview and make you someone they'll want to have on their team.