What is Venture Capital
Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors (NVCA). Venture capital is an important source of equity for start-up companies. These portfolio companies that receive venture capital are thought to have excellent growth prospects. Start-up companies don’t usually have the access to capital markets because they are private. Venture capitalists are one solution to financing high risk, but potentially high reward companies. Usually the investors receive a say in the company’s management, they may be on the board, and they expect to receive returns 5-10 times their investment of up to 50 million dollars (Burk).
History of Venture Capital
It is important to start out with the history of venture capital to see how it has grown as well as to show its ups and downs. It was thought to be developed in the years following WWII but it can actually be dated all the way back to partnerships in the Babylonian Code (Gompers). These Babylonian partnerships used gold or silver to finance caravans. The terms for were 12 years and 100% profits (Heise).
Much later the first venture capital firm was established in 1946. Karl Compton, the MIT President, along with Georges Doriot, a Harvard Business School Professor, formed American Research and Development (ARD). There were also local businesses leaders involved in the project. During the war, there were many new technologies developed as well as other innovations from MIT. About half of ARD’s profits came from its investment in Digital Equipment Company in 1957. It had only invested $70,000 but had grown in value to $355 million.
A decade later, many other venture capital firms were formed. They were all structured as publicly traded closed-end funds as were ARD’s. Closed-end are mutual funds whose shares must be sold to other investors, instead of being redeemed from the issuing firm. In 1958, the first venture capital limited partnership was formed, Draper, Gaither, and Anderson. Others soon followed suit, but limited partnership remained the minority during 1960’s and 1970’s. The rest were either closed-end funds, or small business investment companies. During these years, the total annual venture funds were small and never exceeded a couple hundred million dollars.
In the beginning pension funds were prohibited from investing in venture capital due to the high risk. Because of this, most of the capital raised by individuals in the 70’s. After a much needed change pension funds were allowed to be used, and subsequently accounted for more than half of all the contributions (Gompers). Later there was more change to come and in the late 1980’s and early 1990’s limited partnerships became the dominant form of the venture capital industry.
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