Recently, I’ve noticed that the Media and a number of Mitt Romney’s political opponents have been incorrectly lumping Venture Capital with Private Equity, Buy-out and Hedge Funds in discussions around his track record.   Given the controversy, it’s clear that most people, including reporters, don’t have a solid understanding of the differences between VC and these other practices.

For the record, Mitt Romney began his career as a Venture Capitalist in 1984 (he famously invested in Staples at around the time of its birth).  Bain Capital started with a Venture Model but has evolved into a Private Equity firm around 1989.  Mit went through this transition while at Bain.  Today, Bain is predominantly a Private Equity and Buy-out shop.

So, what’s the difference? 

First, Private Equity firms raise large amounts of money (funds often exceed $1 billion) and deploy that capital into mature companies with significant revenues and cash flows. PE firms commonly take operating positions within the companies they invest.  They will restructure the companies, financially engineer, and sometimes cut workers and businesses.  It is also common practice for Private Equity firms to finance their investments through large amounts of debt in order to minimize their equity investment and enhance their returns through leverage.  These firms do have a vested interest in the growth of the underlying company but can occasionally extract value without growth of sales or employment.  While cost cutting (including employees and business lines) may increase profitability and value in the investment, a combination of cost cutting and growth is typically their best path to outsized returns.

Buy-out firms are similar to Private Equity except that they purchase controlling positions.  It is not uncommon for a Buy-out firm to acquire a publicly traded company and take them private. These firms are even more known for financing their acquisitions with large amounts of debt. Buy-out shops are typically the largest firms, with assets in the billions of dollars.  Blackstone, for example, raised a $15B Buy-out fund.  Some firms, like Bain Capital are both PE and Buy-Out shops.

Hedge funds are nothing like venture firms and have very little resemblance to Private Equity.  Hedge funds invest large sums of money into publicly traded companies, and rarely, if ever join the board.   The SAC Hedge funds totals about $14B.  Hedge funds are purely financial and largely passive investors.  Many funds will bet against companies by shorting their stock and some trade in other markets like currencies and commodities.

In contrast, Venture Capital is aimed at investing in small start-up and early-stage companies.  The average VC firm manages about $300mm per fund and invests roughly $15mm per Company.   Keep in mind that these totals change depending on the stage, and capital requirements of the companies.  Spark’s current fund III is $360mm.  It is not uncommon for VCs to invest in companies at the idea stage with no revenue.  VCs usually join the boards of their investments in order to provide guidance but don’t take an operating role.  VCs typically make equity investments and rarely use leverage beyond a lease line for equipment. 

All venture capitalists make investments with the hope and expectation that there will be growth in the underlying company (and with this growth come jobs).  In fact, most of the money invested by Venture Capital firms goes directly to employees.  What this means is that Venture Capital dollars directly translate into jobs at portfolio companies, as it’s virtually impossible to grow otherwise.

If you look back at the last 30 years (Venture is hardly 40 years old) Venture-funded companies have created tens of millions of jobs in the US.  This number is more impressive when you consider the high paying nature of these jobs.  The estimated number of employees at VC-backed companies in 2011 alone was approximately 12 million or roughly 11% of the total private sector workforce.   That doesn’t include the indirect jobs created within the supply chain of the VC-backed companies.  VC-backed companies accounted for $3.1 trillion of revenue (or roughly 10% of total US sales).  If we assume that this revenue resulted in an additional 30% in supplier revenue and 20% in distributor revenue (both conservative numbers) then VC-backed companies would have produced roughly $4.5 trillion in 2011.  It is my profound belief that VC investments have a major multiplier effect on the economy and employment in America. 

Consider the impact in terms of jobs and US competitiveness if VC-backed companies such as Apple, Intel, Microsoft, Google, Ebay, and Cisco weren’t able to raise the capital necessary to grow.  

One should also keep in mind that the vast majority of capital raised by Venture firms comes from public and private institutions such as Endowments, Foundations, and Pension funds.  And so, the vast majority of the returns generated by the Venture Industry has directly benefitted these organizations over the past several decades. 

While it’s undeniable that Venture and Private Equity Partners have significant economics in their fund outcomes, any income is directly correlated to the success of the Institutions previously mentioned.  VCs receive a management fee, generally between 2% and 2.5% of the money managed, and a percentage of the profits, usually between 20% and 30%.   Private Equity, Buy-out firms and Hedge funds have similar models with some major differences.  The biggest differences are that VC funds tend to be much smaller and generally hold investments longer.   Whether VCs deserve their economics is the subject of another blog post.  

While the main goal of the Venture business is to deliver returns to investors, a clear result is the creation of high paying, high quality jobs.  Companies like Google, Facebook, and Twitter have created thousands of high quality jobs in just the past few months.

Without Venture in the equation the US economy would suffer.  The Country would be less competitive in the Global arena and employ fewer high paid workers.   If you think Banks and the US Government can fill the void, guess again.  They don’t have the expertise or appetite for risk.  To boot, Venture funds contribute to funds Endowments, Foundations and Pensions have to support their constituents and causes.

Therefore, lumping Venture in with Private Equity, Buy-out firms and Hedge funds is inaccurate and unfair.  VCs are fighting the good fight and helping to establish the next generation of great companies that produce high quality jobs and enhance the US economy and global competitiveness.  While the real heroes are the Entrepreneurs, VCs do provide a valuable service to this great Country.  So Newt, Rick, Ron, and the Press, please get your facts straight and don’t throw the baby out with the bathwater.  

thanks to David Haber for his help on this post.