Why Are So Many Tech Companies Backed by Venture Capital?

Venture Capital

If you name a handful of tech success stories from the last decade; Uber, Deliveroo, Airbnb, Netflix, Spotify you’ll find that venture capital played a pivotal role in bringing these firms to the forefront of commerce. 

To investors who have been in the stock market for 40+ years, this is unusual because the round of Initial Public Offerings which took place during the dot-com boom (1998 – 2001) placed the ownership of technology firms into public hands far earlier in the lifecycle of a start-up. 

This meant that firms moved from seed funding to public equity funding within a couple of years and most of the growth in the value of those firms occurred while they were public companies. 

Examples included Microsoft which was valued at $777 million at IPO and Amazon Inc which are was valued at $438 million. Given that both of these firms are worth a combined $2.5 trillion dollars at the time of writing, this helped deliver great returns for many equity investors over the first and second decade of the 21st century. 

Today, billion-dollar ‘unicorn’ firms remain as private companies through most of their growth cycle. Uber Inc finally came to market in an IPO in 2019, but at this stage was already worth a whopping $80 billion. Its market value as of writing three years later remains flat on that original valuation. Venture capital = 1. Retail investors = 0.

So why does venture capital sink its teeth into so many tech firms in the modern-day and why don’t companies go public sooner? Is this state of affairs likely to change, and can retail investors participate in the early growth of tech start-ups any longer? Read on to find out. 

The dominance of venture capital

Venture capital firms are funded by sophisticated investors and managed by a team of partners and analysts who work long hours striking deals with target companies.

VC firms don’t put all their money in one basket; they form funds that they fill with cash and use to take equity stakes in 5 – 30 small businesses. A fund will aim to return cash to investors within 5 – 10 years although this cycle varies from fund to fund. 

A venture capital fund is relatively passive compared to other investors. They may share their expertise with management and promote their new venture but it is rare for VC firms to gain control of a Board or exert direct influence upon the activities of the company. A VC fund is strapped in and taken along for the wild ride. 

Venture capital has become the go-to source of finance within the tech industry because VC firms make funding raising smooth and speedy. They make investments every month of the year and therefore have a professional team that can take the pain out of fundraising. 

Compared to a public offering on the markets, it’s considerably simpler to raise funds via the issuance of private share capital. The parties to the transaction are deemed to be sophisticated and therefore are capable of performing their own due diligence and understanding the risks they are taking. Therefore, there is less red tape and fewer hoops to jump through before an investment can be made. 

The patience of venture capital investors is also attractive to entrepreneurs. If a tech firm were to go public, it would begin publishing audited financial statements every quarter. The demands of shareholders, analysts and the wider public can pressure management into adopting a more short-term view, which can hinder long-term strategic investments which may take several years to show results but would ultimately lead to greater growth. 

Is this likely to change?

The trend is for more and more regulation from financial and market regulators. Therefore it isn’t becoming any easier to operate as a public company. 

The recent innovation of Special Purpose Acquisition Vehicles have made it quicker and cheaper to list a company on a stock exchange, however, the demands once the merger has been completed are just as burdensome.

It would therefore surprise this author if tech firms decided to pivot towards the public markets in the next few years. 

How can investors access growth companies?

Venture capital funds are off the table for average retail investors, because to qualify to invest, an individual must either be very wealthy, have previous experience of investing in private companies, or already work in a professional connected to the provision of finance to business. 

However, other online platforms provide an opportunity to act as a venture capitalist yourself. These are known as ‘crowd-funding’ or ‘seed-funding’ platforms. 

These websites allow you to contribute directly to an equity-funding round by a small or medium business. The company will share their financial projections, business model and a summary of the financial stake they are offering. You can decide to invest £10 upwards into the project. 

Such projects – like real-life start-ups, do not have a high success rate. Therefore, it’s more helpful to frame seed-funding as buying a lottery ticket than making an investment. An expense rather than an asset, where you should only invest money you are not afraid to lose. 

This is actually the same mindset required for venture capital and angel investing in general.

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