One of the defining characteristics of the American economic system is the lengths it goes to protect the claims of entrepreneurs to their own work. It is a sentiment that goes all the way back to the framing of the Constitution. In Article 1, Section 8, Clause 8, or the Copyright Clause, the United States Congress is called upon “To promote the Progress of Science and useful Arts, by securing for limited Times to All Inventors the exclusive Right to their respective Writings and Discoveries.” Armed with constitutional support, intellectual property laws have proven to be a powerful incentive for an American economy predicated on the development of new technologies.
However, as the ecosystem of business has become more complicated, so too has the idea that “Inventors possess the exclusive right to their…discoveries.” Aside from the hefty fees that IP lawyers command, there was also the emergence, around the 1960s, of an investment vehicle known as venture capital. Venture capital has undeniably accelerated the creation of new technologies, by providing capital to speculative ventures that other financial institutions are afraid to fund. At the same time, and in line with the ideals (if not the practices) of the American financial system, the risk is commensurate with the reward. In the case of a successful exit, venture capital firms become richer from companies they invested in than the founders themselves. Is this, somehow, un-American? Actually, it’s just the opposite.
The traditional way to raise money is to take out a loan from a bank. The lender (the bank) then has a legal right to repayment of the original capital plus interest. These commitments are expected to be met, regardless of how successful the entity taking out the loan is. On the other hand, venture capitalists make their investments in exchange for equity. As a result, their ability to make money is tied entirely to the success of the company they have financed. Venture capitalists demand significant returns (and thus significant chunks of a young company’s equity) because of the high level of risk involved. Again, this is risk that traditional banks shy away from.
Aside from the fact that start-ups are often too speculative for traditional forms of financing, the importance of venture capital is also underscored by the dynamism of the new markets that start-ups participate in. The goal of venture capital is to use the money to “scale,” or win as big of a segment of the market as quickly as possible. Doing so, however, is time sensitive. Many new technology initiatives, especially social media and search, thrive on network effects; that is, their value increases dramatically as the number of people using the service increases. The provision of Venture Capital funds ensures that the operation can harness this phenomenon and sustain itself through periods of high-intensity growth.
Given the speculative nature of their work, the only way for entrepreneurs to receive the funding necessary to pursue their visions is to cede some financial control. Entrepreneurs, like Aaron Levie, the founder of Box, a file sharing service with a valuation of $2 billion, get that. Responding to a post on Quora that asked how he felt about his own 4 percent equity stake and having to watch “DFJ and USVP (VC firms in Silicon Valley and New York, respectively) laugh to the bank after 10 years of blood, sweat, and tears,” he responded:
“So far, I have yet to bleed while building Box (well, one time I was late to a meeting and cut myself shaving). And honestly, if anyone is regularly bleeding while building a software company, I would have some serious questions about their strategy and if they’re executing properly. Definitely lots of tears and sweat though. Start your company because you want to change the world, and the rest is gravy.”
This popularly held view of VCs, articulated by Levie, is also influenced by the fact that the value proposition associated with raising venture capital goes beyond just financing. The best ones bring significant managerial and technical experience, having built, run, and sold companies themselves. In fact, this focus on operational experience is a growing trend within the industry, with new funds, particularly Andreesen Horowitz, leading the way. This strengthens the argument that venture-backed firms succeed because of the support they receive from their venture capitalists. In addition to financial capital, entrepreneurs are receiving the intellectual and experiential capital that is necessary to navigate the fast-paced and volatile world of start-ups.
Venture capital will continue to play a role as the industrialized world moves more and more towards a Knowledge Economy. In the first quarter of 2014, over $9.5 billion of venture capital was invested around the world, up 12 percent from the three months during 2013. In the United States, 11 percent of private sector jobs rely on venture financing, while venture-backed companies contribute to 21 percent of US GDP, despite representing a radically smaller proportion of the country’s total number of companies. Perhaps what is most telling about the importance of Venture Capital, and the way it is so well-executed by its American practitioners, however, is the fact that each year, entrepreneurs from around the world flock to the US, Silicon Valley in particular, because they know doing so provides them with the best opportunity to raise the money to scale their ideas. What could be more American than that?
Photo of Aaron Levie via Flickr Commons