Abstract: Venture capital is essentially an arbitrage opportunity between the different values ascribed to an asset by the private and public markets.1 Joseph 'Joe Bananas' Bonanno Sr., former head of one of New York City's five original Mafia families, .. . described himself... as a 'venture capitalist' who invested in businesses with owners who invited him to become a partner because of his connections.2 I. INTRODUCTION Both of the above quotations contain essential truths about the nature of the venture capital industry. The first emphasizes the role of the venture capitalist in identifying and investing funds in young privately-owned companies, the value of which might increase tremendously in the future. The venture capitalist earns her profit several years down the line when some of the companies in her portfolio enter the public market in initial public offerings, or through other exit mechanisms, and are sold for more than she initially invested. Described as such, the function of the venture capitalist is not terribly different from that of other professional investors who use their expertise to identify, buy, and sell equities. Allowing for a broad definition of connections, the second quotation reveals a keen understanding of the important role of the venture capitalist once she has made her initial investment in a start-up company. After all, venture capitalists do not invest only money in start-ups; they also invest their own expertise, managerial skills, time and connections in nurturing a company into profitability.3 The success of the best venture capital firms derives not only from their ability to spot promising young companies, but also from their ability to add value to the everyday running of those companies. In this way, venture capital is much less like a bet on the future prospects of a business, and much more like a helping hand from a talented and well-connected individual with an established reputation for success. The 1990s were blissful days for both venture capitalists and the investors who funded them. Typically raising money through venture capital funds organized as Delaware limited partnerships,4 venture capitalists invested nearly $100 billion in 2000.5 With returns reaching a reported average of 163% in 1999,6 the top venture capital firms were in the enviable position of having a huge surplus of investors vying to act as the limited partners who would provide up to 99% of the funding in each newly raised venture capital fund. Further, after a decade of wildly successful investing, the venture capitalists became able to dictate the terms of the limited partnership agreements governing their relationships with investors, retaining virtually all of the decision-making power, and insisting on increasingly better terms of remuneration for themselves.7 A study of the venture capital industry suggests that, as their reputations grow and demand for their services increases, venture capitalists are able to negotiate limited partnership agreements that impose fewer legal restrictions on themselves.8 Investors willingly entered into such seemingly imbalanced limited partnership agreements because, in a market that produced huge valuations for unproven and still-unprofitable companies, the terms were favorable enough.9 Throughout the 1990s, litigation over disputes between investors in venture capital funds and venture capitalists who controlled those funds was virtually nonexistent. Indeed, the industry as a whole long had a reputation as one in which disputes rarely arose, and were even more rarely resolved through litigation.10 One obvious explanation for this is that even if there were abuses by the general partners, the limited partners had no reason to sue since they were regularly enjoying high returns.11 Another explanation for the absence of litigation in the industry is that the parties, both the limited and the general partners, developed a culture that relied on a powerful non-legal enforcement mechanism: reputation. …
Publication Year: 2003
Publication Date: 2003-04-01
Language: en
Type: article
Access and Citation
Cited By Count: 11
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