Venture Capital Is the Essence of Everything Good in Capitalism

2/14/12

I was heartened this month to see that the Private Equity Growth Capital Council launched a multi-million-dollar education and public affairs campaign on the Internet highlighting the basics of private equity. Hopefully, this will address a general lack of understanding about private equity, which, among other things, is too often confused with venture capital.

This misperception was in the spotlight last month, when Republican and Democratic attacks focused on Mitt Romney’s time as the head of private equity firm Bain Capital. The message was that Romney was a “vulture capitalist,” defined as an investor consumed with maximizing profit, often by terminating hundreds, sometimes thousands of jobs. Romney is not and was not a vulture capitalist, a mean-spirited, derogatory term sometimes used to describe venture capitalists (VCs). Romney was a private equity investor, one who specialized mostly in leveraged buyouts.

Unlike leveraged buyouts, venture capital funds invest in new, often unproven businesses. The equity that venture capital firms invest usually commands a preferred return to compensate for high risk. But VCs earn nothing unless there is a successful financial exit for the companies they help start, an exit in which all shareholders benefit. Exits usually take years, and in the interim venture capitalists work alongside the founders and management of the companies they back. If the company is successful, all shareholders, not just VCs, make a return. And if the company fails, VCs typically lose their entire investment.

As company builders, venture capitalists provide managerial and technical expertise to the companies in which they invest. They also bring experience and contacts. Most important, they help entrepreneurs take new ideas and turn them into new products and businesses and thus create jobs—sometimes thousands of jobs. And, overwhelmingly, these are good, highly skilled jobs.

According to the National Venture Capital Association (NVCA), venture-backed companies outperformed the total U.S. economy between 2008 and 2010—a litmus test of performance in an unusually harsh economic environment. Employment at VC-backed companies did fall—by 2 percent—but that was well under the 3.1 percent decline in overall private employment in the same period.

At the same time, companies backed by venture capital generated a 1.6 percent gain in revenue, compared to a 1.5 percent decline for the corporate world as a whole. Other NVCA figures are equally telling. For every dollar of venture capital invested from 1970 to 2010, $6.27 of revenue was generated by the venture-backed companies in 2010. And while annual venture investment equals less than 0.2 percent of U.S. gross domestic product, VC-backed companies typically generate about 21 percent of U.S. GDP.

The best part is the jobs that venture capital creates. According to the NVCA, 11.9 million people worked at venture-backed companies in 2010—that’s 11 percent of U.S. private sector employment. The $3.1 trillion in revenue at venture-backed companies amounted to10 percent of total U.S. sales.

It’s really no surprise why VC-backed companies outperform their non-venture counterparts during good times and bad. It boils down to venture capital’s focus on highly innovative, emerging growth companies. According to the NVCA, the 500 largest public companies with venture capital roots saw their collective market capitalization rise by about $700 billion between 2008 and 2010, from $2.1 trillion $2.8 trillion.

Venture capital’s likely impact on the U.S. economy remains bright. That’s because many of the fastest-growing venture-backed companies in the U.S., such as Facebook, have yet to go public. According to IHS Global Insight, 92 percent of job growth for young companies occurs after their initial public offerings.

The upshot is abundantly clear. If VCs make good deals, workers and many others win. And if VCs fail, they and their limited-partner investors pay almost the entire penalty by losing the money they invested. This is exactly the way capitalism is supposed to work. Success never comes without risk, but it is that risk that makes success all the more satisfying. Venture capital is the essence of everything good in capitalism.

Nat Goldhaber is a co-founder and managing director of Claremont Creek Ventures in Oakland, CA. Follow @

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  • Bob Wilcox

    The VC model has indeed been great for entrepreneurs, investors, and the job market. However:
    VCs have moved away from early medical device ventures in favor of low-risk, late stage entities. This model mimics other low-return investment strategies, and foreshadows a downturn in the successful job creation you cite.
    Comparing revenues to same year investment dollars is no longer meaningful, given the dramatic recent shifts in volume and risk-tolerance. Analyses of returns have not been flattering to the overall VC market, and may explain the exodus of investors.
    The performance of innovative companies reflects positively on innovators, and suggests that VCs are wise to back them. It would be interesting to quantify innovators relying on boot-strapping, joint venture, Angels, grants, and self-financing. Comparing their performance to the VC-backed innovators might reveal other effective investment methods for producing jobs.
    I strongly support the premise that investing in innovation, tolerating risk, and sharing management expertise is the best way to create interesting jobs and a healthy economy. I think credit goes to the innovators: VCs are fortunate to have access to them, and as VCs shrink from risk, innovators will create new models of financing.

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  • http://claremontcreek.com Nat Goldhaber

    There is a rugged group of VCs who doggedly invest in seed and early stage companies. That is what Claremont Creek does and that is what most of our syndicate partners (co-investors) do. We may represent a an endangered species, but we love risk and hope for reward.

    Early stage invests typically are very hands-on. We are almost an extension of a new company’s management team, pitching in to fill gaps in experience and knowledge during company very early grow stages. Contrast this with the style of a class of angel investors who have more of the “through some capital at the wall and see what sticks.” So too, late stage investors often have little hands-on contact with their portfolio companies leaving their expertise to the rarefied exchanges during board meetings.

    Time will tell what style of investing has the best payback to the limited partners (the investors) of venture funds. My bet – obviously – is with early stage. That’s where venture began an I think it is where venture will pay off.

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