Last week I was at a conference on Sand Hill Road, which is in Menlo Park, Calif. The highway is nothing special, kind of rustic looking. But Sand Hill Road is the nerve center of venture capital in Silicon Valley. Some of the firms located there include Andreessen Horowitz, Sequoia Capital, Battery Ventures and Greylock Partners. It reminded me of the importance that venture capital firms have in the current business landscape.
To understand why venture capital is so important, let’s first take a brief look at its history. Interestingly enough, venture capital is a fairly young practice, with the roots going back to the early 1970s. At the time, several tech veterans like Tom Perkins and Don Valentine saw huge opportunities to provide funding for emerging startups.
Until this point, the money often came from “angels” — that is, rich entrepreneurs who would pony up $50,000 to $100,000 per deal. But venture capital was much different. The approach was to raise millions from institutional investors (called “limited partners”) and then redeploy money into startups.
The irony is that firms like Kleiner and Sequoia had a tough time publicizing their advantages. The fact was that most entrepreneurs did not understand venture capital. So, to get things started, the pioneering venture capital firms would create their own companies, which allowed them to show what kind of advantages venture capital firms could offer! This was the case with breakout companies like Genentech, which was essentially started in the conference room at Kleiner Perkins.
But by the 1980s, the tech community started to understand venture capital — and funding exploded. The result was that it became much easier to scale companies, as seen with Oracle (ORCL), Adobe (ADBE), Electronic Arts (EA), Intuit (INTU) and on and on.
In terms of the structure of venture capital, the template was similar to a private equity fund. There would be general partners that sought out investments and earned 2% on assets under management. Then there would be an incentive fee of 20% of the profits.
All in all, it turned out to be extremely lucrative, especially with the massive boom of PCs and the Internet. Consider that a variety of venture capital partners have become billionaires like Sequoia’s Michael Moritz and Kleiner Perkins’ John Doerr. But these partners are far from coupon clippers. It’s extremely tough to become a partner, and becoming a successful partner is even more difficult. The fact is that tech has a graveyard of failed companies. Remember Pets.com? Webvan?
The rule-of-thumb is that 90% of venture capital deals will fail or go nowhere. Because of this, the key to making profits is to find the next big thing. It’s all about swinging for the fences.
A venture capital partner will also usually take a hands-on approach to building a company. First of all, they will often have experience as an entrepreneur. So they understand the challenges and difficulties of coming up with innovative technologies and getting customers to take a chance on something new. But a venture capital partner can be extremely helpful in providing key introductions to partners and customers.
And by having the backing of a venture capital firm, a company gains instant credibility. The VC firm makes it easier to attract top engineers and executives. For example: The main reason Meg Whitman left Disney (DIS) for eBay (EBAY) was that EBAY was backed by Benchmark Capital.
And that’s why venture capital is so important: Think of all of the companies that might never have gotten off the ground without support from VC. In some cases, a venture capital firm may actually look like a startup factory. This is certainly the case with Google Ventures, which helps with recruiting, scaling, partnerships, sales and even design. (For more information, check out my recent post on the firm.)
Now it’s true that venture capitalists can make blunders. And some may even deserve the tag as “vulture capitalists.” But these are the exception, not the rule. Given that Silicon Valley is a close-knit community, a nefarious venture capitalist will not last long.
Angel investors also remain a critical part of the startup ecosystem. A prime example of this is Peter Thiel, who made the initial $500,000 investment in Facebook (FB) (and also made our list of most eccentric billionaires). Interestingly enough, Thiel would go on to start his own venture capital firm.
Without venture capital, it seems impossible that the U.S. would have achieved this pace of innovation over the last 30 years, particularly with the Internet and mobile technologies. Consider that 20% of the total value of the Nasdaq have had venture capital from Sequoia!
In light of this, it is any wonder that many countries have tried to replicate the Silicon Valley model? Not at all. And as long as venture capital firms remain strong, we can expect the pace of innovation and improvement to keep on growing.
Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.