“Venture Capital” is a term being thrown around a lot, and I thought it could be a good idea to explore what exactly the purpose of venture capital is in the modern day. Venture capital (VC) is similar to Private Equity, where investors, usually institutions or very wealthy investors, commit money to a fund that will invest in assets outside public exchanges in search of outsized returns. Venture capital seeks to create these returns by investing in startup companies that promise returns significantly higher than the invested capital. The catch is that most startups will go broke and return nothing. Unlike other forms of private equity, like leveraged buyouts, the best venture capital firms tend to have consistently better track records than the average firm. However, accurately assessing the present value of a venture capital fund is a fool’s errand, since it depends on the ultimate success of the companies it invests in. Additionally, venture capital funds must present investors with returns when the fund hits its termination date, meaning they need to liquidate their holdings. Since the venture capitalist wants to multiply any investment, it is unlikely that the required gains can come from actual earnings, as it is very difficult for a company to have large profits in its first couple of years of operations. Therefore, in order to give the desired return to limited partners, called the distribution, a venture capitalist must seek to have the company get bought by someone else or go public.
Merely looking at what sort of companies venture capitalists prefer shows how this set of circumstances has created a peculiar environment. VC is overwhelmingly dedicated to the tech sector. Moreso, VC is only interested in companies that have the potential for tremendous scale. In many cases, the options are to wildly succeed or go bust. If a company has the choice between making a sustainable but mediocre profit or burning through money in an attempt to take over the world, many times VCs will push the latter option. This reinforces the narrative that venture capital is a vehicle for the very rich who can afford to burn money.
The convergence of an all-or-nothing attitude with the need for companies to transition to public markets has had several consequences. When a VC-backed startup has an initial public offering, investors expect a steady and sustainable business that will be a good investment for normal people. But this isn't what VCs create. A result of this attitude has been the mediocre performance of such VC-backed, take-over-the-world startups such as Uber and Facebook, not to mention outright failures such as Theranos and WeWork. However, venture capital can move past these failures by remembering its purpose, to foster and promote technologies that will revolutionize the world for the better. That is what justifies the expectation for investments to multiply tenfold. The choice is up to us.