The Evolution and Regulation of Venture Capital Funds

Abstract

Fundraising is one of the biggest challenges for venture capitalists in the wake of the financial crisis, causing some to argue that the venture capital model is broken? Maybe it looks that way, but actually the answer is that fundraising works differently. Indeed, this Paper shows that a ‘Darwinian’ evolution has led to profound changes in the venture capital industry – particularly in the area of venture capital fundraising. Venture capitalists should take these new trends and developments into account when deciding on how to structure future venture capital funds. This conclusion is based on empirical data that shows trends and developments in entrepreneurial finance and investments up to the first half of 2012. A few developments spring to mind, such as institutional investors taking a more active approach towards fund managers, the revival of corporate venture capital, the focus on investments in later stage startup companies, the development of micro-venture capital funds and the emergence of ‘joint’ funds. This paper discusses four strategies that may be deployed by venture capitalists. The first strategy relates to the ‘survival of the fittest’ trend. It appears that the best performing venture capitalists are still able to attract sufficient interest from institutional investors. They may only have to slightly tweak the traditional venture capital fund agreement to offer more protection to the institutional investors. A second strategy, involving the introduction of ‘innovative’ contractual provisions, aims to target more active investors. By offering customized separate accounts arrangements and deal-by-deal investment opportunities, fund managers attempt to attract these investors. The third strategy is moved by the idea that strategic – often corporate – investors will be able to improve and accelerate the fundraising process. Finally, venture capitalists can take a real partnership-type approach by setting up a new fund in which investors are selected on the basis of particular abilities and affinities. This paper holds important lessons for venture capitalists and their advisors, but also for policymakers and regulators who are increasingly contemplating the introduction of ‘venture capital regulations’.

Keywords: Alternative Investment Funds Managers Directive, corporate venture capital, Dodd-Frank Wall Street Reform and Consumer Protection Act, European Venture Capital Funds Regulation, fundraising, government venture capital, institutional investors, limited partnership agreement, venture capital

JEL Classification: G20, G23, G24, K20, K22, L22, L26, L51