First, a quick note: I've differed with Vinod Khosla a couple of times on this site in the past. But let's give him his due as well. Read the story I've linked to here, and be inspired. Such drive and audaciousness is what venture capital is really all about -- and what makes great entrepreneurs. Especially in cleantech, where so many customers are change-resistant, all entrepreneurs and VCs should read this story and take it to heart.
What exactly is a 'venture capital investment'?
A definition seems obvious ('startup capital') but of course becomes devilishly difficult to place within specific boundaries. Generally speaking, VC as a subset of private equity is provided to early-stage companies that are still privately held and are too immature to be able to get debt financing. But even at this level, there are lots of areas of debate. Can't many startups get 'venture debt'? And is funding a raw startup at its inception phase really to be considered in the same category as putting money into a 'final round' before an IPO, for a fast-growth business?
It really doesn't matter (except under Dodd-Frank, I guess) what you label an investment. I hear phrases like "growth equity," "pre-IPO funding," and "seed capital" being bandied about as subcategories, for example, and the differences between them are broad but fuzzy. I think what's more important is that so-called venture capital investments are those that are carried out using venture capital terms, as opposed to majority-ownership type transactions or simple common-share purchases. VC terms are arcane and convoluted to outsiders, but basically boil down to two things: a) making sure that the minority-ownership 'risk capital' gets strong returns at some liquidity event, with some downside protection; and b) making sure that the minority-ownership 'risk capital' gets lots of protections against dramatic shifts to the business by the management team or other insiders. In other words, it's very mechanical, what makes a 'venture capital' round, as typically reported as a "Series [_]" investment, versus what would have been considered another form of capital investment into the same company. By default, if we're talking Series A or Series B, etc., it's probably not confusing -- only angels and VCs and government would put money into the company at a pre-revenue stage. But it gets tricky when you see companies with not-insignificant revenue taking in a pre-IPO "Series F" or such. Is that "venture capital"?
It doesn't really matter. At that point, the terms are being designed according to the VC template versus other templates simply because mostly VCs remain around the table. So sure, call it VC -- or whatever.
Except that reporters and numbers-trackers glom onto such deals as "venture capital rounds," because they're labeled as such, and because VCs participate in the funding.
And then these fundings, which are typically very much larger than the usual earlier-stage venture rounds and have much lower returns expectations, are all piled into the same "VC funding" category when it comes time at the end of the quarter for pundits to declare whether or not things are healthy in the entrepreneurial world.
You just can't treat these deals that way. If there are 200 $4M Series A investments into a sector, that demonstrates much more investor excitement and optimism about a sector than four $200M Series F investments. And it feeds into bubble talk, as well -- pundits look at a really large headline number about the total "venture capital" dollars going into a sector and declare it to be over-invested, because there's no way all that capital can achieve "venture capital returns." But first of all, what are "venture capital returns" anyway? Obviously, it varies greatly by stage, according to risk versus reward (and besides, the VC category has really underperformed against the Efficient Frontier over the last decade, anyway). So if you see a $200M Series F, are investors really expecting to get the 10x return that early-stage VCs typically hope to achieve? Does that really mean it's a "bubble"?
So because the definition of venture capital is so fuzzy, you just can't look at the top-line totals and expect to glean any knowledge about investor expectations for sectoral growth and returns. Journalists need to remember this.
LPs need to bear this in mind, as well. They get pitched by "venture capital" funds that declare themselves as such, but are increasingly looking to invest in companies with well-established revenue and clear paths to exit. Not that there's anything wrong with that at all! We've done some of that investing at my private equity (note: NOT "venture fund") investment group ourselves. But it's easy for LPs to look at such pitches as being "venture capital returns, with lower risk." No -- it's lower risk, perhaps, but also comes with lower expected returns. That can be a totally justifiable tradeoff. But it's important to realize that it is indeed a trade-off. And so if the LP is truly looking for the upside of "venture capital returns," they need to make sure they have exposure to the early-stage firms in a sector, not just the growth stage and multi-stage (i.e., 80% growth stage) firms.
As the cleantech venture capital category continues to swerve toward later-stage investing, such distinctions matter more and more to LPs, journalists, and others in the space. Entrepreneurs don't really care -- a Series F by any other name would smell as sweet -- but you, gentle reader, should remember that not every "venture capital" financing you are told about should really be considered as such. Thus, not every "big quarter for cleantech venture capital" is actually a sign of health for startups in the sector. I always say that if you're going to track just one number, track the number of transactions, not the dollar total of the transactions. It's still not a perfect metric, but it's less susceptible to definitional drift.