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Why Venture Capital is Key to Our Economic Recovery

Feb 25, 2009 | Updated May 25, 2011

As we continue to reel from the unthinkable (as in "what were we thinking?") excesses of gorging on huge amounts of unsecured debt throughout our economy, we need to think clearly about the financial tools that will allow us to recover our footing, grow our economy and create well-paid sustainable jobs. While debt financing will undoubtedly make a comeback, albeit in a more prudent mode, real equity will have to be invested if we want to break the cycle that got us here in the first place.

One of the proven methods of deploying equity to finance innovation and the creation of new enterprises is venture capital.

Venture capital funds invest in new or unproven enterprises. These funds come in the form of equity that is invested in new companies. While this equity usually commands a preferred return to compensate for the risk of backing unproven companies, venture capital funds do not earn any return unless there is a financial "exit" for the organization as a whole in which all shareholders benefit. Until that exit (which can take many years), the venture capitalists (VCs) stand shoulder-to-shoulder with the founders and management of the companies they back, for better or worse. If the company fails, the VCs typically lose all. If the company is successful, the VCs make a return -- but so do the other shareholders.

Venture capitalists bring managerial and technical expertise to the companies they invest in. They bring experience and open their Rolodex. They find multiple ways to be helpful, to promote the companies' varied agendas. But VCs don't manage the companies directly. They are minority shareholders who act as advisors to the brilliant innovators, the individuals whose ideas will create whole new markets or transform existing ones.

The U.S. has the most developed and sophisticated venture capital industry in the world. The industry has helped build significant companies in technology (Compaq, Yahoo, Google), biotech (Genentech), health care, medical devices, financial services (eTrade), retail (Home Depot), renewable energy and pretty much every segment of the economy.

Despite these successes, venture capital represents a tiny and largely misunderstood part of the financial services sector. Venture capital is also known as "risk capital" since only a relatively small number of new companies will be successful -- and a smaller number yet will be the next Google. However, VC funds are organized in pools of capital -- capital which is invested in a portfolio of companies -- and the returns are derived from the combined results of that pool. Over the years, venture capitalists have delivered positive returns as an asset class. Venture capital investments also take a few years to mature and, as a result, have largely been avoided by investors looking for quick returns in a booming stock market (when that existed).

Venture capital is also often equated with private equity, two business models which couldn't be more different. Private equity (PE) used to be known as leverage buy-outs or "LBOs" (someone figured out early that "leverage" would become a detested term). PE firms generally acquire controlling interests in public companies by investing a combination of a small amount of equity and a large amount of debt (slapped onto the acquiring company's balance sheet). These firms then manage these companies with a tight fist, extracting as many fees and dividends as they can get away with. In a euphoric market, returns to the PE funds and its limited partners can be large and quick. In today's market, that business model is dead while the venture capital model lives on.

Big companies have been shedding jobs for years. In the current economy, big companies are jettisoning employees at a furious pace. These companies are not going to be hiring any time soon. When the economy picks up, they'll find ways to stay lean. The only source of new jobs (apart from the government, and that's another story) will come from start-ups and existing small businesses. We need a lot of new businesses to pick up the slack. We need more venture capital.

But at a time when we should be expanding VC funding, the opposite is likely to happen. Pension funds and endowments are among the largest sources of new capital for VCs. Their portfolios of public stocks have declined so much that their usual allotment for venture funds is over the authorized levels. And a majority of these funds lump venture capital and private equity into the same category -- one which, given the broken model of private equity, is now viewed with a great deal of skepticism.

Most venture capitalists are experienced, responsible professionals with outstanding track records of successfully growing new companies that have benefited society through innovation and new jobs. Depriving VC funds of sources of capital at a time when they're needed the most will only slow our economic recovery further. Pension funds, endowments and other venture limited partners should continue to set aside pools of capital with long-term appreciation, and view venture capital as a single asset class -- one that is key to our economic recovery.

Full Disclosure: I am a Managing Partner at venture capital fund Softbank Capital, an investor in The Huffington Post and I am on the Board of the company.