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Venture capitalists usually have a time horizon of three to seven years for their investments. This means that the VCs expect to be able to satisfactorily exit the investment in one of several ways within that timeframe. The most common exit strategy for VCs involves the company merging with or being acquired by another company. The exit strategy that garners the most press and hoopla, however, is an initial public offering, or IPO. An initial public offering occurs when a company's equity is made available for investment through the public markets. Over the last 25 years, almost 3000 companies backed by venture capitalists have gone public, according to the National Venture Capital Association, an industry trade group.
According to the National Venture Capital Association, last year 50% of all IPOs were venture-backed, versus 20% for the year before. Plus, venture-backed companies are going public earlier now, compared to years past, and on average, they are commanding higher offer sizes and post-offer valuations. The median age of a venture-backed IPO last year was 4 years, compared to 4.5 years in 1998, and 5.5 years in 1997. Total valuation of the venture-backed companies last year on their IPO dates was $136.2 billion.
What are some of the downsides of venture capital funding? First and foremost is the loss of some control for the founders of the company. Remember, venture capitalists won't make an investment in a young company without equity, or ownership, in return, which means, logically, that the founders have to give up some of theirs. This in itself is not a bad thing, but if a company goes with a VC firm that turns out to have an agenda contrary to the founders' vision of the company, conflict between the founders and the venture investors could arise. And because the founders are somewhat beholden to the VC firm, they'll pretty much have to listen to what the VCs suggest.
Also, because of the desire of most VCs to exit an investment in three to seven years, there could be time pressure on the company to go public before it wants to. If the VC firm thinks the company should go public, they have the will and the means to actively encourage the company to do so. A company that wishes to remain privately held will make sure the VCs know this going into the deal. Even with this caveat in place, the VCs may still seek to pressure the company into going public, or at the very least, may try to broker an acquisition of the company. All VCs have exit strategies, and companies accepting their funds shouldn't forget this fact.
New Trends in Venture Capital
New trends in venture capital financing have sprouted up in the last few years, fueled by strong economic growth and the beginnings of an everyman-is-an-entreprenuer-on-the-Internet kind of mentality. The first trend is exemplified by garage.com. Garage.com, founded by Apple Computer's former "chief evangelist" Guy Kawasaki, seeks to provide a place to connect technology start-ups with potential investors, and vice versa. At garage.com, angel investors, for instance, can "shop" for new prospects to invest in, and new technology companies that need financing can sell themselves to a ready and willing audience. It takes out a lot of the intimidation a start-up might face trying to get a VC firm to give it the proverbial "five minutes" of face-time. Garage.com specializes in "seed level" investments, which are investments made in the earliest stages of a company's development.
By taking a look at where Amazon.com (Nasdaq: AMZN) had been spending its money over the last few years, we can see the second trend in venture capital financing. Amazon has bought ownership stakes, many significant, in a variety of other Internet start-ups. Amazon owns stakes in pet stores (Pets.com), drugstores (Drugstore.com), groceries (HomeGrocer.com), online car buying (Greenlight.com), sporting goods (Gear.com), and wish lists (Della.com) to name just a few of its investments. Amazon.com's investment portfolio is estimated to be worth close to $700 million, as laid out for us in this Rule Breaker report. Expect other companies to follow Amazon's lead in the future. On the Internet (as in "real life"), placement and location are everything, and owning parts of the right companies can be very complimentary -- and profitable -- to your business model.
Another trend in VC is the rise of a certain breed of risk-taking individual investor. There are investors today who increasingly behave like venture capitalists by buying into (typically) Internet companies they know, use, and believe in. Investors buying Amazon.com, for example, are behaving like venture capitalists. They are betting that this young pioneering company is on to something big and will be profitable down the road.
In a recent Rule Breaker portfolio report, David Gardner encouraged Fools with a taste for risk and the ability to effectively tolerate it to invest like venture capitalists. By this he means a situation where an investor will make a reasoned choice to possibly lose all of his investment, alongside the founders of the company, in order to own a part of it by buying the company's stock. As David writes in The Motley Fool's Rule Breakers, Rule Makers, "Venture capitalists buy ownership, and do so more qualitatively. They use their guts to find people with guts, and they buy into them." This is the Rule Breaking approach to investing, and it's not for everyone, as there is more risk involved with this type of investing compared with buying established companies.
Venture capital financing is not nearly the behind-the-scenes tricky stuff we might think it is. There's no magic little man hiding behind the curtains pulling levers and shaking the money tree. At its core, it's really just people investing in companies they believe in and want to see have a long and profitable future. Not so different than you and me, eh? Venture on, Fool.
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