This was an answer to a Quora question titled, “Is Venture Capitalism a Blessing on Earth?”
I’m not sure if there’s religious undertones implied by “blessing on Earth,” but…
Venture capitalism enables innovations and services that better everybody involved and create value across the spectrum.
Some years ago, it was trendy to refer to venture capitalists as “vulture capitalists,” and to confuse venture capitalism with private equity deals. And while the terms can be broad and you could see some overlap, they’re very different things (both very necessary tools in our current economic landscape — if you want an explanation of private equity and how it works, ask me in the comments).
But venture capital is the money given to startups and early stage companies to help them grow more quickly than they would otherwise. It can be broken down into angel investing, then seed investing, then small venture capital, then large venture capital plays. This is all part of venture capitalism, but “venture capital” tends to refer to larger rounds (usually in the millions of dollars). Venture capital is a tool. Tools are value-neutral. A tool can be used for good or bad. Venture capitalism is a system that makes venture capital a viable tool.
Venture capitalists are entrepreneurs in their own right. They create value.
They see an opportunity that others are passing up (namely, investing in a company with the potential for high growth), and put their money where their mouths are. They help companies that would not otherwise grow as quickly (or grow at all!), and these companies go on to invest the money into serving customers. If people freely buy the company’s services or products, the company is creating value for people — enabled by the Venture Capitalist.
Venture capital helps takes companies from experimental-product phase to market.
Sure, sometimes (i.e., Most of the time) the companies fail. But the venture capitalist helps the entrepreneurs test the market and find out better ways that we can serve one another.
Venture capital enables entrepreneurs to better serve us, the consumers, making us all better off.
Enabling High Growth
What can I possibly mean by the VCs enable companies to grow that otherwise wouldn’t?
There are a couple ways that companies can fund their growth:
- Debt Financing — usually in the form of loans from banks. This is a great option for companies that can leverage existing equity against the loans (i.e., companies with physical inventory, land, profits) and is great for companies that know if they invest $X in the company, they can create Y > $X + ($X(i)) where X is the money on loan from the bank, i is the interest rate, and Y is the Return On Investment. Debt financing is usually good for small businesses with tested business plans and existing enterprises (these are companies that are more likely to know that investing X in a given area will result in Y payoff).
- Crowdfunding — using sites like Kickstarter and IndeGogo, you can get a lot of people to donate smaller amounts to your project in exchange for some kind of gift. The difference here is that they don’t get paid back and they don’t get equity. This is good for things like boutique manufacturing and retail products. Not great for capital-intensive operations where you need to raise millions of dollars.
- Equity Financing — This is where Venture Capital normally falls. An individual (Angel Investor) or firm (Venture Capital Firm) will offer $X in exchange for Y% of the company. If the company is acquired by another company or is taken public onto the stock market, they get the payout relative to the amount of the company they own. Larger investors tend to be given board seats and have a say in how the company is managed. This is good for companies that are trying something totally new or need to test the waters in different ways. They may not know that $X investment in Z area will result in Q ROI, but they want to test it. It provides more flexibility than debt financing because there isn’t a date that the company must IPO or be acquired (although most firms only invest in companies they believe can achieve this in a given timeframe, like 5, 10, or 15 years) and because the money doesn’t have to be paid back. It’s best for companies that have an opportunity to exponentially grow the investment, rather than linearly grow it. Accelerators and incubators fall into this category, too. Places like Y Combinator offer mentorship and support, as well as a cash investment, in exchange for equity in the company.
- Other — You get some new mixes and forms now. With the passage of the US JOBS Act, you can get Angel Investor Syndicates, which work a lot like crowdfunding for angel investments. You also have companies like Able Lending (Collaborative Small Business Lending) that combine traditional Small Business loans with an element of VC-like fundraising, giving you access to larger loans earlier.
You will also find some combination of these at different stages. For example, a company like Uber might take an investment from a large investment bank like Goldman Sachs that has a requirement on the investment that the company must IPO within 24 months or else they have to pay the investment back with interest.
Imagine a company that wants to launch a new, never-before-seen product. They have tested the waters and have shown some very basic feasibility in the product, but they know that they need to hire salespeople, developers, and offer promotional discounts to really grow and develop the product. Banks probably wouldn’t give a loan to this company anyway — what does it have to leverage if they can’t pay back the loan? — and a loan wouldn’t provide the flexibility needed to really grow the company.
So the founders approach a venture capitalist. They explain to them that this product serves a quickly growing market in a way that is better, faster, and cheaper than the existing competition. They tell the VC that with their money, they can expand into new markets, offer new services, and serve more customers. The VC enables the company to create more value for everybody involved — the company, the customers, and himself. Everybody wins.
This doesn’t mean that there aren’t bad VCs. You can find horror stories online about VCs meddling in the affairs of a company after offering an investment, or pushing the company to be acquired when the founders would rather take it along further to an IPO. And some VCs back companies that can never be profitable — meaning the company is destroying value (the same way that subsidized companies destroy value).
But at the end of the day, Venture Capital is a tool that allows entrepreneurs to better serve the rest of us. Tools are value-neutral — they can be good or they can be bad. But venture capitalism, the system that makes such investments possible, is a net-good. Many of the technological advances of the information age were brought to market by VC-backed companies: Apple, Microsoft, Uber, Facebook, PayPal, Google, Airbnb, and many others. Where would we be without the entrepreneurs and the products they bring to the fore that better our lives every day?