how venture capital works

Before you can understandthe industry, you must

first separate mythfrom reality.

HOWVENTURECAPITALWORKS

BY BOB ZIDER

INVENTION AND rNNOVATiON drive the U.S. economy.What's more, they have a powerful grip on the nation'scollective imagination. The popular press is filled with

against-all-odds success stories of Silicon Valley entrepre-neurs. In these sagas, the entrepreneur is the modern-daycowboy, roaming new industrial frontiers much the sameway that earlier Americans explored the West. At his sidestands the venture capitalist, a trail-wise sidekick readyto help the hero through all the tight spots-in exchange,of course, for a piece of the action.

As with most myths, there's some truth to this story.Arthur Rock, Tommy Davis, Tom Perkins, Eugene Kleiner,and other early venture capitalists are legendary for the

Bob Zideris president of the Beta Group, a fum that develops andcommercializes new technology with funding from individuals, com-panies, and venture capitalists. It is located in Menlo Park, California.

HARVARD BUSINESS REVIEW November-December 1998 131

HOW VENTURE CAPITAL WORKS

parts they played in creating the modern computerindustry. Their investing knowledge and operatingexperience were as valuahle as their capital. But asthe venture capital business has evolved over thepast 30 years, the image of a cowboy with his side-kick has become increasingly outdated. Today'sventure capitalists look more like bankers, and theentrepreneurs they fund look more like M.B.A.'s.

The U.S. venture-capital industry is enviedthroughout the world as an engine of economicgrowth. Although the collective imagination ro-manticizes the industry, separating the popularmyths from the current realities is crucial to under-standing how this important piece of the U.S. econ-omy operates. For entrepreneurs (and would-be en-trepreneurs), such an analysis may prove especiallybeneficial.

Venture Capital Fills a VoidContrary to popular perception, venture capitalplays only a minor role in funding basic innovation.Venture capitalists invested more than $10 billionin r997, but only 6%, or $600 million, went to start-ups. Moreover, we estimate that less than $1 billionof the total venture-capital pool went to RikD. Themajority of that capital went to follow-on fundingfor projects originally developed through the fargreater expenditures of governments ($63 billion)and corporations (S133 billion).

Where venture money plays an important role isin the next stage of the innovation life cycle-theperiod in a company's life when it begins to com-mercialize its innovation. We estimate that morethan 80% of the money invested by venture capital-ists goes into huilding the infrastructure required togrow the business-in expense investments (manu-facturing, marketing, and sales) and the balancesheet (providing fixed assets and working capital).

Venture money is not long-term money. The ideais to invest in a company's balance sheet and infra-structure until it reaches a sufficient size and credi-bility so that it can be sold to a corporation or sothat the institutional puhlic-equity markets eanStep in and provide liquidity. In essence, the ven-ture capitalist buys a stake in an entrepreneur'sidea, nurtures it for a short period of time, and thenexits with the help of an investment banker.

Venture capital's niche exists because of thestructure and rules of capital markets. Someonewith an idea or a new technology often has no otherinstitution to turn to. Usury laws limit the interestbanks can charge on loans-and the risks inherentin start-ups usually justify higher rates than al-lowed by law. Thus bankers will only finanee a new

PROFILE OF THE IDEALENTREPRENEUR J

From a venture capitalist's perspective, the idealentrepreneur:• is qualified in a "hot" area of interest,• delivers sales or technical advances such as FDA

approval with reasonable probability,• tells a compelling story and is presentable to

outside investors,• recognizes the need for speed to an IPO for

liquidity,• has a good reputation and can provide references

that show competence and skill,• understands the need for a team with a variety

of skills and therefore sees why equity has to bealUieated to other people,

• works diligently toward a goal but maintainsflexibility,

• gets along with the investor group,• understands the cost of capital and typical deal

structures and is not offended by them,• is sought after by many VCs,• has realistic expectations about process and

outcome.

business to the extent that there are hard assetsagainst which to secure the debt. And in today's in-formation-based economy, many start-ups havefew hard assets.

Furthermore, investment banks and public equityare both constrained by regulations and operatingpractices meant to protect the public investor. His-torically, a company could not access the publicmarket without sales of about $ 15 million, assets of$10 million, and a reasonable profit history. To putthis in perspective, less than 2% of the more than5 million corporations in the United States havemore than $10 million in revenues. Although theIPO threshold has heen lowered recently throughthe issuance of development-stage company stocks,in general the financing window for eompanies withless than $10 million in revenue remains closed tothe entrepreneur.

Venture capital fills the void between sources offunds for innovation (chiefly corporations, govern-ment bodies, and the entrepreneur's friends andfamily) and traditional, lower-cost sources of capi-

132 HARVARD BUSINESS REVIEW November-December 199H


tal available to ongoing concerns. Filling that voidsuccessfully requires the venture capital industryto provide a sufficient return on capital to attractprivate equity funds, attractive returns for its ownparticipants, and sufficient upside potential to en-trepreneurs to attract high-quality ideas that willgenerate high returns. Put simply, the challenge isto earn a consistently superior return on invest-ments in inherently risky business ventures.

Sufficient Returns at Acceptable RiskInvestors in venture capital funds are typically verylarge institutions such as pension funds, financialfirms, insurance companies, and university endow-ments-all of which put a small percentage of theirtotal funds into high-risk investments. They expecta return of between 2 5 % and 3 s % per year over thelifetime of the investment. Because these invest-ments represent such a tiny part of the institutionalinvestors' portfolios, venture capitalists have a lotof latitude. What leads these institutions to investin a fund is not the specific investments but thefirm's overall track record, the fund's "story," andtheir confidence in the partners themselves.

How do venture capitalists meet their investors'expectations at acceptable risk levels? The answerlies in their investment profile and in how theystructure each deal

The Investment Profile. One myth is that venturecapitalists invest in good people and good ideas.The reality is that they invest in good industries-that is, industries that are more competitively for-giving than the market as a whole. In 1980, for ex-ample, nearly 20% of venture capitalinvestments went to the energy in-dustry. More recently, the flow of cap-ital has shifted rapidly from geneticengineering, specialty retailing, andcomputer hardware to CD-ROMs,multimedia, telecommunications, andsoftware companies. Now, more than25% of disbursements are devotedto the Internet "space." The apparentrandomness of these shifts amongtechnologies and industry segments is misleading;the targeted segment in each case was growing fast,and its capacity promised to be constrained in thenext five years. To put this in context, we estimatethat less than 10% of all U.S. economic activity oc-curs in segments projected to grow more than 15 % ayear over the next five years.

In effect, venture capitalists focus on the middlepart of the classic industry S-curve. They avoidboth the early stages, when technologies are uncer-

tain and market needs are unknown, and the laterstages, when competitive shakeouts and consolida-tions are inevitable and growth rates slow dramati-cally. Consider the disk drive industry. In 1983,more than 40 venture-funded companies and morethan 80 others existed. By late 1984, the industrymarket value had plunged from $5.4 billion toSr.4 billion. Today only five major players remain.

Growing within high-growth segments is a loteasier than doing so in low-, no-, or negative-growthones, as every businessperson knows. In otherwords, regardless of the talent or charisma of indi-vidual entrepreneurs, they rarely receive backingfrom a VC if their businesses are in low-growthmarket segments. What these investment flowsreflect, then, is a consistent pattern of capital allo-cation into industries where most companies arelikely to look good in the near term.

During this adolescent period of high and acceler-ating growth, it can be extremely hard to distin-guish the eventual winners from the losers hecausetheir financial performance and growth rates lookstrikingly similar. [See the chart "Timing Is Every-thing.") At this stage, all companies are strugglingto deliver products to a product-starved market.Thus the critical challenge for the venture capital-ist is to identify competent management that canexecute - that is, supply the growing demand.

Picking the wrong industry or betting on a tech-nology risk in an unproven market segment issomething VCs avoid. Exceptions to this rule tendto involve "concept" stocks, those that hold greatpromise but that take an extremely long time tosucceed. Genetic engineering companies illustrate

The myth is that venturecapitalists invest in good people

and good ideas. The reality is thatthey invest in good industries.

this point. In that industry, the venture capitalist'schallenge is to identify entrepreneurs who can ad-vance a key technology to a certain stage-FDAapproval, for example - at which point the companycan be taken public or sold to a major corporation.

By investing in areas with high growth rates, VCsprimarily consign their risks to the ability of thecompany's management to execute. VC invest-ments in high-growth segments are likely to haveexit opportunities because investment bankers are



TIMING IS EVERYTHINGMore than 80% of the money invested by venturecapitalists goes into the adolescent phase of a com-pany's life cycle. In this period of acceleratedgrowth, the financials of both the eventual win-ners and losers look strikingly similar.

Venture Capitalist- * - Investment - ^ -

Period

time

« Start-upJ: Adolescence• Maturity and shakeout

continually looking for new high-growth issuesto bring to market. The issues will be easier to selland likely to support high relative valuations - andtherefore high commissions for the investmenthankers. Given the risk of these types of deals, in-vestment bankers' commissions are typically 6%

to 8% of the money raised through an IPO. Thusan effort of only several months on the part of a fewprofessionals and brokers can result in millions ofdollars in commissions.

As long as venture capitalists are able to exit thecompany and industry before it tops out, they canreap extraordinary returns at relatively low risk.Astute venture capitalists operate in a secure nichewhere traditional, low-cost financing is unavail-able. High rewards can be paid to successful man-agement teams, and institutional investment willbe available to provide liquidity in a relatively shortperiod of time.

The Logic of the Deal. There are many variants ofthe hasic deal structure, but whatever the specifics,the logic of the deal is always the same: to giveinvestors in the venture capital fund both ampledownside protection and a favorable position foradditional investment if the company proves to bea winner.

In a typical start-up deal, for example, the ven-ture capital fund will invest $3 million in exchangefor a 40% preferred-equity ownership position, al-though recent valuations have been much higher.The preferred provisions offer downside protection.For instance, the venture capitalists receive a liqui-dation preference. A liquidation feature simulatesdebt by giving 100% preference over commonshares held hy management until the VC's $3 mil-lion is returned. In other words, should the venturefail, they are given first claim to all the company'sassets and technology. In addition, the deal oftenincludes blocking rights or disproportional votingrights over key decisions, including the sale of thecompany or the timing of an IPO.

The contract is also likely to contain downsideprotection in the form of antidilution clauses, orratchets. Such clauses protect against equity dilu-tion if subsequent rounds of financing at lowervalues take place. Should the company stumbleand have to raise more money at a lower valua-tion, the venture firm will he given enough sharesto maintain its original equity position-that is,the total percentage of equity owned. That prefer-ential treatment typically comes at the expense ofthe common shareholders, or management, aswell as investors who are not affiliated with theVC firm and who do not continue to invest on apro rata basis.

Alternatively, if a company is doing well, in-vestors enjoy upside provisions, sometimes givingthem the right to put additional money into theventure at a predetermined price. That means ven-ture investors can increase their stakes in success-ful ventures at below market prices.

134 HARVARD BUSINESS REVIEW November-December 1998


HOW THE VENTURE CAPITAL INDUSTRY WORKS

The venture capital industry has four main players: entrepreneurs who need funding; investorswho want high returnsj investment hankers who need companies to sell; and the venture capi-talists wht) make money for themselves by making a market for the other three.

Ideas

Venturecapitalists IPOs

Investmentbankers

I ICorporations and

governmentPrivate

investors

Stock

Public marketsand corporations

VC firms also protect themselves from risk hycoinvesting with other firms. Typically, there willbe a "lead" investor and several "followers." It isthe exception, not the rule, for one VC to finance anindividual company entirely. Rather, venture firmsprefer to have two or three groups involved in moststages of financing. Sueh relationships provide fur-ther portfolio diversification-that is, the ability toinvest in more deals per dollar of invested capital.They also decrease the workload of the VC partnersby getting others involved in assessing the risksduring the due diligenee period and in managingthe deal. And the presence of several VC firms addscredibility. In fact, some observers have suggestedthat the truly smart fund will always be a followerof the top-tier firms.

Attractive Returns for the VCIn return for financing one to two years of a com-pany's start-up, venture capitalists expect a tentimes return of capital over five years. Combinedwith the preferred position, this is very high-costcapital: a loan with a 58% annual compound inter-est rate that cannot be prepaid. But that rate is nec-essary to deliver average fund returns above 20%.

HARVARD BUSINESS REVIEW November-December 1998

Funds are structured to guarantee partners a com-fortable income while they work to generate thosereturns. The venture capital partners agree to returnall of the investors' capital before sharing in the up-side. However, the fund typieally pays for the inves-tors' annual operating budget-2% to 3% of thepool's total capital-which they take as a manage-ment fee regardless of the fund's results. If there isa $ 100 million pool and four or five partners, for ex-ample, the partners are essentially assured salariesof $200,000 to $400,000 plus operating expenses forseven to ten years. (If the fund fails, of course, thegroup will be unable to raise funds in the future.)Compare those figures with Tommy Davis andArthur Rock's first fund, which was $5 million buthad a total management fee of only $75,000 a year.

The real upside lies in the appreciation of theportfolio. The investors get 70% to 80% of the gains;the venture capitalists get the remaining 20% to30%. The amount of money any partner receivesbeyond salary is a function of the total growth of theportfolio's value and the amount of money managedper partner. (See the exhibit "Pay for Performance.")

Thus for a typical portfolio-say, $20 millionmanaged per partner and 30% total appreciation onthe fund-the average annual compensation per

135


PAY FOR PERFORMANCE

ANNUAL IRK OF FUND OVEK f tVE YEARJi:

o% io% 20% 30% 40% 50%

AVERAGE ANNUAt COMPENSATION (iN MILLIONS)$20 million managed per partner:

0.2 0.6 1.4 2.4 3.8 5.4

AVERAGE ANNUAL COMPENSATION (iN MILLIONS)$30 million managed per partner:

0.3 0.9 2.1 3.6 5.5 (.1

partner will he about $2.4 million per year, nearlyall of which comes from fund appreciation. Andthat compensation is multiplied for partners whomanage several funds. From an investor's perspec-tive, this compensation is acceptahle heeause theventure capitalists have provided a very attractivereturn on investment and their incentives are en-tirely aligned with making the investment a success.

What part does the venture capitalist play in max-imizing the growth of the portfolio's value? In anideal world, all of the firm's investments would bewinners. But the world isn't ideal; even with thehest management, the odds of failure for any indi-vidual company arc high.

On average, good plans, people, and businessessucceed only one in ten times. To see why, considerthat there are many components critical to a eom-pany's success. The best companies might have an80% probability of succeeding at each of them. Buteven with these odds, the probability of eventualsuccess will be less than 20% because failing to ex-ecute on any one component can torpedo the entirecompany.

INDIVIDUAL EVENT PROBABILITY

Company has sufficient capital 80%Management is capable and focused 80%Product development goes as planned 80%Production and component sourcinggoes as planned 80%Competitors behave as expected 80%Customers want product 80%Pricing is forecast correctly 80%Patents are issued and are enforceable 80%COMBINED PROBABILITY OF SUCCESS 17 %

If just one of the variables drops to a 50% probability,the combined chance of success falls to 10%.

Tbese odds play out in venture capital portfolios:more than half the companies will at best returnonly the original investment and at worst be totallosses. Given the portfolio approaeh and the dealstructure VCs use, however, only io% to 20% ofthe companies funded need to be real winners toachieve tbe targeted return rate of 25% to 30%. Infact, VC reputations are often built on one or twogood investments.

A typieal breakout of portfolio performance per$1,000 invested is shown below:

BAD ALIVE OKAY GOOD GREAT TOTAL

$ INVESTED 2 0 0 400 200 IOO TOO T,000

O IX S'' lOX 2OX

GROSS

PAYOUTYEAR S

RETURN

NETRETURN

o 400 1,000 1,000 2,000 4,400

(200} o 800 900 1,900 3,400

Those probabilities also have a great impaet onhow the venture capitalists spend their time. Littletime is required (and sometimes hest not spent) onthe real winners-or the worst performers, callednumnuts ("no money, no time"). Instead, the VCallocates a significant amount of time to thosemiddle portfolio companies, determining whetherand how the investment can be turned around andwhether continued participation is advisable. Theequity ownership and the deal structure describedearlier give the VCs the flexihility to make manage-ment changes, partieularly for those companieswhose performance has heen mediocre.

Most VCs distribute their time among many ac-tivities (see the exhibit "How Venture CapitalistsSpend Their Time"). They must identify and attractnew deals, monitor existing deals, allocate addi-tional capital to the most successful deals, and as-sist with exit options. Astute VCs are able to allo-cate their time wisely among the various functionsand deals.

Assuming that each partner has a typical portfo-lio of ten companies and a 2,000-hour work year,the amount of time spent on each company witbeach activity is relatively small. If the total timespent with portfolio eompanies serving as directorsand acting as consultants is 40%, then partnersspend 800 hours per year with portfolio eompanies.That allows only 80 hours per year per company-less than 2 hours per week.

The popular image of venture capitalists as sageadvisors is at odds with the reality of their sched-ules. The financial incentive for partners in the VC

136 HARVARD BUSINESS REVIEW November-December 1998


firm is to manage as muchmoney as possible. Themore money they manage,the less time they have tonurture and advise entre-preneurs. In fact, "virtualCEOs" are now heing addedto the equity pool to coun-sel eompany management,which is the role that VCsused to play.

Today's venture capitalfund is structurally similarto its late 1970s and early1980s predeeessors: thepartnership ineludes bothlimited and general part-ners, and the life of thefund is seven to ten years. (The fund makes invest-ments over the course of the first two or three years,and any investment is active for up to five years. Thefund harvests the returns over the last two to threeyears.) However, hoth the size of the typical fundand the amount of money managed per partnerhave changed dramatically. In 1980, the averagefund was about $20 million, and its two or threegeneral partners each managed three to five invest-ments. That left a lot of time for the venture capitalpartners to work directly with the companies,hringing their experience and industry expertise tobear. Today the average fund is ten times larger, andeaeh partner manages two to five times as many in-vestments. Not surprisingly, then, the partners areusually far less knowledgeable about the industryand the technology than the entrepreneurs.

The Upside for EntrepreneursEven though the structure of venture capital dealsseems to put entrepreneurs at a steep disadvantage,they continue to suhmit far more plans than actu-ally get funded, typically by a ratio of more than tento one. Why do seemingly brigbt and capable peopleseek such high-cost capital?

Venture-funded companies attract talented peo-ple by appealing to a "lottery" mentality. Despitethe high risk of failure in new ventures, engineersand businesspeople leave their jobs because theyare unahle or unwilling to perceive how risky astart-up can he. Their situation may he compared tothat of hopeful high school basketball players, de-voting hours to their sport despite the overwhelm-ing odds against turning professional and earningmillion-dollar incomes. But perhaps the entrepre-neur's behavior is not so irrational.

1HOW VENTURE CAPITALISTS SPEND THEIR TIME

Activity

Soliciting businessSelecting opportunities

Analyzing business plansNegotiating investments

Serving as directors and monitors ^amt^^^mm^^^^^^mm 25%Acting as consultants { ^ • • ^ ^ ^ ^ • H 15%

Recruiting management ^^^a^m^^^^m^ 20%Assisting in outside relationships

Exiting

Consider the options. Entrepreneurs-and theirfriends and families-usually laek the funds to fi-nance the opportunity. Many entrepreneurs alsorecognize the risks in starting their own businesses,so they shy away from using their own money.Some also recognize that they do not possess all thetalent and skills required to grow and run a success-ful business.

Most of the entrepreneurs and managementteams that start new companies come from corpo-rations or, more recently, universities. This is logi-cal because nearly all basic research money, andtherefore invention, comes from corporate or gov-ernment funding. But those institutions are hetterat helping people find new ideas than at turningthem into new businesses (see the exhibit "WhoElse Funds Innovation?"). Entrepreneurs recognizethat their upside in eompanies or universities islimited by the institution's pay structure. The VChas no sueh caps.

Downsizing and reengineering have shatteredthe historical security of corporate employment.The corporation has shown employees its versionof loyalty. Good employees today recognize the in-herent insecurity of their positions and, in return,have little loyalty themselves.

Additionally, the United States is unique in itswillingness to embrace risk-taking and entrepre-neurship. Unlike many Far Eastern and Europeancultures, the culture of the United States attaeheslittle, if any, stigma to trying and failing in a newenterprise. Leaving and returning to a corporationis often rewarded.

For all these reasons, venture capital is an attrac-tive deal for entrepreneurs. Those who lack newideas, funds, skills, or tolerance for risk to startsomething alone may be quite willing to be hired



WHO ELSE FUNDSINNOVATION?

The venture model provides an engine for com-mercializing technologies that formerly lay dor-mant in corporations and in the halls of acade-mia. Despite the $133 billion U.S. corporationsspend on R&D, their basic structure makes en-trepreneurship nearly impossible. Because R&Drelies on a cooperative and collaborative envi-ronment, it is difficult, if not impossible, forcompanies to differentially reward employeesworking side hy side, even if one has a brilliantidea and the other doesn't. Compensation typi-cally comes in the form of status and promotion,not money. It would he an organizational andcompensation nightmare for companies to try toduplicate the venture capital strategy.

Furthermore, companies typically invest inand protect their existing market positions; theytend to fund only those ideas that are central totheir strategies. The result is a reservoir of talentand new ideas, which creates the pool for newventures.

For its part, the government provides two in-centives to develop and commercialize newtechnology. The first is the patent and trademarksystem, which provides monopolies for inven-tive products in return for full disclosure of thetechnology. That, in turn, provides a hase for fu-ture technology development. The second is thedirect funding of speculative projects that corpo-rations and individuals can't or won't fund. Suchseed funding is expected to create jobs and boostthe economy.

Although many universities bemoan the factthat some professors are getting rich from theirresearch, remember that most of the research isfunded hy the government. From the govern-ment's perspective, that is exactly what their$63 billion in RtiJD funding is intended to do.

The newest funding source for entrepreneursare so-called angels, wealthy individuals whotypically contribute seed capital, advice, andsupport for businesses in which they themselvesare experienced. We estimate that they provide$20 billion to start-ups, a far greater amountthan venture capitalists do. Turning to angelsmay be an excellent strategy, particularly forbusinesses in industries that are not currently infavor among the venture community. But for an-gels, these investments are a sideline, not a pri-mary business.

into a well-funded and supported venture. Corporateand academic training provides many of tbe tecb-nological and business skills neeessary for the taskwhile venture capital contributes both tbe financ-ing and an economic reward structure well beyondwbat corporations or universities afford. Even if afounder is ultimately demoted as the companygrows, he or she can still get rich because the valueof the stock will far outweigh the value of any for-gone salary.

By understanding how venture capital actuallyworks, astute entrepreneurs can mitigate theirrisks and increase their potential rewards. Manyentrepreneurs make the mistake of thinking thatventure capitalists are looking for good ideas w hen,in fact, they are looking for good managers in par-ticular industry segments. The value of any indi-vidual to a VC is thus a function of the followingconditions:• the number of people within the high-growthindustry that are qualified for the position,-- the position itself (CEO, CFO, VP of R&D,technician];• the match of the person's skills, reputation,and incentives to the VC firm;• the willingness to take risks; and• the ability to sell oneself.Entrepreneurs who satisfy these conditions cometo the table with a strong negotiating position. Theideal candidate will also have a business trackrecord, preferably in a prior successful IPO, thatmakes the VC comfortable. His reputation will besuch that the investment in him will be seen as aprudent risk. VCs want to invest in proven, suc-cessful people.

Just like VCs, entrepreneurs need to make theirown assessments of the industry fundamentals, theskills and funding needed, and the probability ofsuccess over a reasonably short time frame. Manyexcellent entrepreneurs are frustrated by what theysee as an unfair deal process and equity position.They don't understand the basie economics of theventure business and the lack of financial alterna-tives available to them. The VCs are usually in theposition of power by being the only source of capi-tal and by having the ability to influence the net-work. But the lack of good managers who can dealwith uncertainty, high growth, and high risk canprovide leverage to the truly competent entrepre-neur. Entrepreneurs who are sought after by com-peting VCs would be wise to ask the followingquestions:• Who will serve on our board and what is thatperson's position in the VC firm?• How many other boards does the VC serve on?

138 HARVARD Bt;SINESS REVIEW November-December 1998


• Has the VC ever written and funded his or herown business plan sueeessfully?• What, if any, is the VCs direct operating ortechnical experience in this industry segment?• What is the firm's reputation with entrepreneurswho have been fired or involved in unsuccessfulventures?

The VC partner with solid experience and provenskill is a true "trail-wise sidekick." Most VCs, how-ever, have never worked in the funded industry orhave never been in a down cycle. And, unfortunately,many entrepreneurs are self-absorbed and believethat their own ideas or skills are the key to success.In fact, the VCs financial and business skills playan important role in the company's eventual sue-cess. Moreover, every company goes through a lifecycle; each stage requires a different set of manage-ment skills. The person who starts the business isseldom the person who can grow it, and that personis seldom the one who can lead a much larger com-pany. Thus it is unlikely that the founder will bethe same person who takes the company public.

Ultimately, the entrepreneur needs to show theventure capitalist that his team and idea fit intothe VCs current focus and that his equity participa-

tion and management skills will make the VCs jobeasier and the returns higher. When the entrepre-neur understands the needs of the funding sourceand sets expeetations properly, both the VC and en-trepreneur can profit handsomely.

Although venture capital has grown dramaticallyover the past ten years, it still constitutes only atiny part of the U.S. economy. Thus in principle, itcould grow exponentially. More likely, however,the cyclical nature of the public markets, with theirhistoric booms and busts, will cheek the industry'sgrowth. Companies are now going public with val-uations in the hundreds of millions of dollars with-out ever making a penny. And if history is anyguide, most of these companies never will.

The system described here works well for theplayers it serves: entrepreneurs, institutional in-vestors, investment bankers, and the venture capi-talists themselves. It also serves the supporting castof lawyers, advisers, and accountants. Whether itmeets the needs of the investing public is still anopen question. ^

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