Venture Capital: No Longer a Business of Small Investments in Early Stage Companies

Venture capital is very different today than it was in the 1980’s when the industry experienced a wave of growth in response to changes in tax and pension laws. Back in the days when Apple Computer and Genentech were young start-ups, venture capitalists made smaller investments in earlier stage companies with less follow on funding than they do now.

Today it’s not surprising to hear that companies like Facebook or Groupon have raised over $350 million in a single venture capital round. But back in the early 1980s no companies were raising those amounts ($150 million back then in real dollar terms).

Venture capital no longer early stageClick for larger chart (in new window)

Investment rounds are bigger now than they used to be. If we exclude the anomalous bubble years of 1999 and 2000 when the average venture capital investment round reached $20.6 and $36.1 million (in 2008 dollars) respectively, initial investment rounds are much higher now than they were in the 1980s and 1990s. National Venture Capital Association (NVCA) numbers reveal that over the ten year period from 1989 through 1998, the average venture capital round was only $3.8 million (in 2008 dollars). From 2001 to 2010, it was $5.9 million (in 2008 dollars). That’s a 55 percent increase in real dollar terms.

What led to this dramatic rise in the size of venture capital investment rounds? Two causes jump out from the data. The first is a sizeable increase in the amount of follow on funding provided by venture capitalists, which now dwarfs initial funding in a way that was not the case in earlier years. The NVCA data show that in 2010, venture capitalists made $4.10 in follow on investments for every dollar they initially invested in young, high growth companies. While this ratio is down slightly from its record in 2009, it remains far higher than it used to be. Before 2001, the ratio of follow on investment to initial funding had never even reached 3:1.

A second reason for the increased size of venture capital rounds has been a movement toward later stage investments. Although the share of early stage investments has inched back up over the past several years, it remains low by historical standards. From 2001 to 2010, seed and start-up stage investments averaged only 8.9 percent of the total. By contrast, for the period from 1991 to 2000 early stage investments accounted for 18.7 percent of all investments and for the decade from 1981 to 1990, they averaged 25.1 percent.

Although it once was, the venture capital industry is no longer about making small, early stage investments in high potential companies. Today venture capital is much more about larger, later stage deals involving much follow on financing.

Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.