A Successful Venture

The venture capital model is not broken, nor does it need to radically change. In fact, its future looks quite bright.

Venture capital (VC) has fueled many of the most successful start-ups of the last 30 years. Microsoft, Apple, and Google—three of the biggest companies in the United States—were once backed by VC firms. Many well-known and highly valuable companies such as eBay, Amazon, Yahoo, and Starbucks likewise started out with funding from venture capitalists. The VC model of financing young and untested companies with high growth potential has been so successful, it has been replicated all over the world.

Recently, however, critics are saying that the U.S. VC industry needs to shrink and drastically change in order to survive. They say the industry has been generating weak returns, that it has too much capital but too few opportunities to exit investments as demonstrated by the sharp drop in initial public offerings (IPOs) in recent years, and that the markets that have made it successful in the past—notably, information technology and telecommunications—are now maturing.

But according to a recent study by University of Chicago Booth School of Business professor Steven N. Kaplan and Josh Lerner of Harvard Business School, the U.S. VC industry is not broken; it is simply going through the expected ups and downs of a competitive market. In the study titled “It Ain’t Broke: The Past, Present, and Future of Venture Capital,” Kaplan and Lerner show the amount of money committed by investors to this asset class as well as the amount invested by VC firms in the last 30 years has been remarkably constant. In addition, average returns to VC funds do not appear to be unusually low or high relative to stock market returns, even in recent years.

In fact, based on the historic relationship between commitments to VC funds and subsequent performance, the historically low level of funds committed in 2009 and likely 2010 suggest that the returns to investing in these funds will be relatively strong, say Kaplan and Lerner. Moreover, the declining importance of central corporate R&D facilities in favor of buying small firms to acquire the latest technologies is another reason to be optimistic about the future of the VC industry.

The Efficient Man in the Middle

Entrepreneurs have good ideas but sometimes do not have the money to set them in motion. Investors, on the other hand, have the resources but may lack good ideas. In this case, VC firms step in to bring entrepreneurs and investors together. They do this in three ways.

First, VCs spend a lot of time and effort screening, evaluating, and selecting investment opportunities. It is an intensive and disciplined process that typically takes place over several months. VCs scrutinize the attractiveness and risks of the external environment—the market size, competition, and potential for customer adoption; the feasibility of the strategy and technology; the quality of the management team; and the terms of the deal.

Second, VCs efficiently design contracts in such a way that if the entrepreneur is performing well, he or she is well compensated. If the company is running smoothly, VCs do not have to get involved in the company. However, if the company performs poorly, the contracts stipulate that VCs can take full control. As performance improves, the entrepreneur obtains more control rights. It also is common for VCs to include provisions that would make it very costly for the entrepreneur to leave suddenly after investors have already made a significant investment in the company.

Third, VCs play an important role in improving the outcomes of their portfolio companies, mainly by monitoring management and giving valuable advice. This often means replacing the entrepreneur when it becomes clear that he or she is not up to the task of growing the company. Moreover, VCs assist the entrepreneur by helping formulate strategies, hire other executives, and by introducing the entrepreneur to customers and other business partners.

Although only a tiny fraction of new businesses (about one-sixth of one percent) receive VC funding in the United States each year, a very large percentage of small businesses that do well enough to go public are backed by VCs. Since 1999, between 50 and 60 percent of IPOs have been VC-backed firms. In other words, it is highly unlikely that a company that did not receive VC funding will end up going public.

Is the VC Model Broken?

Kaplan and Lerner are skeptical of claims that the VC model is broken, that there is too much money in the industry, or that it needs to radically change because of poor performance and opportunities. They argue that the empirical evidence suggests otherwise.

Compared to the total value of the stock market, the amount of money committed to VC funds has been remarkably stable over the last 30 years. Since the 1980s, VC commitments have never gone below 0.05 percent of the total stock market value or above 0.23 percent, except during the 1999 to 2001 internet technology boom. This figure has been slightly above the historical average since 2002. Similarly, VC investments have never exceeded 0.20 percent of the value of the stock market. Since 2002, investments have been slightly below the historic average.

The returns to investing in venture capital also have neither been unusually high nor low relative to investing in the stock market. Previous analysis by Kaplan and Massachusetts Institute of Technology professor Antoinette Schoar on the performance of funds raised prior to 1997 shows that returns net of fees paid to VCs are competitive compared to stock market returns, and exceed stock market performance gross of fees.

Kaplan’s and Lerner’s assessment of VC funds invested from 2001 to 2005 likewise indicates that the returns from these vintages were roughly equal to that of the stock market. Although there are some limitations to estimating the performance of more recent funds, the authors’ estimates may understate VC fund performance to the extent that bad investments have been written down while better investments have not yet been written up in value.

There also is evidence of persistent performance. Kaplan and Schoar find that if a VC firm earns a good return on one fund, it tends to perform well on subsequent funds, especially if the fund belongs to the top one-third in terms of outperforming the stock market. This is substantially different from findings in other asset classes. Previous research on mutual funds, for instance, finds no evidence of persistence among top performers.

Fund size, however, is the enemy of persistence. VCs who have funds with good returns tend to get bigger while those with funds that earn poor returns tend to get smaller or have difficulty raising additional money. But a recent study by Lerner and his co-authors finds that at some point—about $200 million—returns stop increasing with size, then begin to decline when the size of the fund is greater than $500 million.

This relationship between fundraising and performance extends to the industry as a whole. When the industry’s performance is strong, investors pour more money into venture capital. However, when more capital is committed or invested realized returns suffer, investors eventually pull out. Thus, the industry has a self-correcting mechanism—a period of poor returns that leads to decreased inflows, which, in turn, leads to a recovery of returns. Indeed, Kaplan and Lerner find that the amount of capital committed and invested in a particular vintage year and the previous year are predictive of the average return in that vintage year.

Thus, if numerous investors are thinking of ending their commitments to this asset class, as critics claim, it may be good news for VC investors. Historically, reduced capital inflows are associated with higher returns in the future.

There is a concern, however, that it is more difficult to take a company public than in the past, which would undermine one of the most important ways VCs exit or sell a company. In the 1990s, there were more than 100 VC–backed IPOs a year in all but one year. In the bear market of 2001 to 2003, however, this number dropped to below 50 a year. This is not unusual in a recession. However, VC–backed IPOs failed to bounce back in 2004 to 2007, staying low at slightly more than 50 a year despite the robust stock market and the large number of companies that received VC funding in previous years.

Some say there were so few IPOs partly because it was very costly for public companies to comply with the Sarbanes-Oxley legislation, and also because of the lack of attention from investment banks that were able to make more money from other activities. However, Kaplan and Lerner think it is possible that these constraints have eased and that there will be more VC–backed IPOs in the future, which would boost returns to venture capital.

A Rich Source of R&D

Changes to the U.S. corporate research and development system also are likely to have a positive effect on the future of the VC industry. For most of the 20th century, corporate R&D in the United States was centralized and set up within companies as campus-like facilities that employed thousands of researchers, many of whom were free to pursue fundamental science with little direct commercial applicability. These include Bell Laboratories and IBM Central Research, whose researchers have won several Nobel Prizes.

But because of intense competition and disappointing commercial returns, U.S. corporations began to rethink the role of centralized research facilities. Firms started to reduce the size of these facilities in favor of divisional laboratories and “open innovation”—that is, alliances with and acquisitions of smaller firms—to meet their technology needs.

This development is not surprising. Previous research by Harvard University professor Michael Jensen suggests that the poor performance of research-intensive firms would have been avoided had high-powered incentives—similar to those given by VCs—been offered. Moreover, a study by Lerner and Samuel Kortum of the University of Chicago Department of Economics finds that VC–backed firms are about three times as efficient in generating innovations as corporate research.

Thus, the demand for VC–backed companies is likely to drive the growth of the VC industry for years to come. In fact, the practice of growing companies for full or partial acquisition by larger firms has been going on for many years in the computer networking business. Moreover, because corporate research spending in the United States is many times larger than the magnitude of VC investments, the size of this opportunity is likely to be substantial.

"It Ain't Broke: The Past, Present, and Future of Venture Capital." Steven N. Kaplan and Josh Lerner.