Having spent the best part of the last few years delving into the world of cybersecurity innovation, I started to question just what is driving the sheer amount of entrepreneurism. If you were being optimistic, you might say it’s the pure challenge of keeping pace with the innovative approaches our adversaries use to compromise what is important to us. However, in reality, it’s the same thing most of our adversaries seek – financial gain.
Meeting with new technology companies, they are always keen to let me know just what round of funding they have received. But what does it really mean? What is venture capital?
In this post I will cover; what is venture capital, why does it exist and why pay attention to it.
Venture capital's niche exists largely due to the structure and rules of capital markets. As has been demonstrated by the sheer volume of funding ploughed into the cybersecurity market, new innovators and start-ups often have no other institution to turn to in order to help fund their creations. Usury laws limit the interest other lenders can charge on a loan and the inherent high risk profile of start-up organisations justify higher interest rates than allowed by the law. Therefore, money lenders will only finance a new business that has physical assets in which to secure the loan against. In today's cybersecurity start-ups, little, if any, have any hard assets.
In step the venture capitalists.
Venture capital fills the void between sources of funds for innovation (in a variety of different markets) and the traditional methods of securing low cost capital for ongoing concerns. The challenge in filling the void is that the venture capital industry must demonstrate the ability to deliver sufficient return on the capital in order to continually attract funding. In short, they must demonstrate continual high returns in risky business ventures.
Typically, these funds come from the larger institutions such as financial firms, pension funds, insurance companies, government investment etc. These organisations put a small percentage of a larger fund into these 'high risk' investments. These investors expect 15% or more return on their investment per year over the life of the investment. However, they don’t look to invest in specific investments they invest based on the track record of the specific venture capitalist.
How do venture capitalists meet the needs of their investors at appropriate risk levels? This comes down to their investment profiles and fund diversity. Venture capitalists understand not all of their investments will bear fruit. However when one of the organisations they have invested in goes public, which either sells shares on a stock exchange or gets acquired, the cash flow allows the venture capitalist to cash out and place the proceeds back in the fund. These returns are normally large and more than cover the expected losses of the non-fruitful investments. According to research by William Sahlman at Harvard Business School, 80% of a typical venture capital fund’s returns are generated by 20% of its investments.
Why should we pay attention to this? Put simply, identifying the most successful venture capitalists and identifying where they are placing their funds, gives potential insight into what might just be the next big innovation in our industry. However, we need to bear in mind that typically only one out of five of those invested in will succeed, so due diligence is certainly required.