Genetically engineered: why some venture capital firms are more successful than others

Entrepreneurship: Theory and Practice, Jan, 2009 by Jennifer M. Walske, Andrew Zacharakis

The Venture Capital Firm

At the center of the venture capital process is the VCE Venture capital is secured from LPs who invest in specific venture capital funds, but hold no operational duties. In the early days of venture capital, LPs were often wealthy individuals. However, since changes to the Employee Retirement Income Security Act came into effect in 1979, pension funds have surpassed private individuals as contributors to venture capital (Gompers & Lerner, 2004). The dominant investment vehicle for the VCF is a venture capital fund (Sahlman, 1990). Capital within these funds is invested in entrepreneurial companies, also known as portfolio companies (PCs), the majority of which are privately held. General Partners (GPs) at VCFs make and manage all fund investments, bringing "... their own set of capabilities to identifying skilled entrepreneurs and helping them build their businesses" (Gompers, Kovner, Lerner, & Scharfstein, 2006, p. 1). In return, GPs collect management fees and retain a share of the profits, called "carried interest," in the PCs in which they invest. A return on an investment (ROI) is realized when the PC is either sold or reaches an initial public offering (IPO). However, this transformation of illiquid capital into a tradable commodity takes time (Gorman & Sahlman, 1989), with a venture fund typically maturing after a 10-year incubation period (The NVCAYearbook, 2006). Each time a new fund is raised, a VCF will solicit existing and new LPs (Gompers, 1996). The most successful VCFs will raise cascading and sequential funds, securing new funds before the prior funds have closed.

The problem for the first-time VCF is that large pension funds (e.g., CalPERS) need to invest at least $50 million per fund, while at the same time, not own more than 10% of the fund. This often disqualifies new and smaller VCFs that are not fundraising at this level (Braunschweig, 2003). LPs also ask for disclosures on fund performance before considering an investment opportunity. However, the interim internal rate of return (IRR) on a new fund is subject to great volatility (Sahlman, 1990). Therefore, for a first-time VCF to attract LPs, VCs often reference their successful investments at prior VCFs (Burton & Scherschmidt, 2004; Gompers & Lerner, 1996). This gives VCFs founded by experienced VCs a competitive advantage when fundraising. As a result, Burton and Scherschmidt observed that many first-time VCFs (8 out of 20 surveyed) relied on individuals and corporations rather than "institutional funds" (e.g., pension funds or endowments) as sources of capital in their first funds.

Pilot Interviews

Prior to embarking on a quantitative analysis, we conducted semi-structured interviews with LPs and VCs to increase our understanding of the issues that new VCFs face. We interviewed seven individuals for this study: four VCs from newly founded VCFs and three LPs. The four VCs had founded VCFs between 1996 and 2000 and had a variety of prior experiences, ranging from operating entrepreneurial companies to being GPs at established VCFs. Of the three LPs we interviewed, one LP was a private investor and two LPs were institutional investors. A corpus of field notes was used for coding and analysis (Glaser, 1978).