To Understand This Risk Aversion, you've got to know more about how VC firms are organized. First, a venture capitalist isn't a guy with a giant bag of money over his shoulder, dollar bills and gold coins spilling out. Behind the cartoon character is not one but several different people with different roles. The people with big money to invest—sometimes billions of dollars—don't know much about technology and innovation. Instead, they turn their money over to people who do (or so they hope).

Basically, venture capitalists combine these investments into a sort of mutual fund of start-ups. As the start-up passes through various well-defined stages of development, other investors are brought in to fund the company, thereby lessening the risk, and also the potential reward, as the fund matures. It turns out that most investors won't fund an operation before it has a measurable cash flow, so it takes a special investor to put money into a company at its earliest stages of existence.

VCs talk about funding rounds in alphabetical order. Series A investments are backing something that's little more than a technology and a team. The business will need to acquire other skills, such as sales, marketing, customer service, and operations management, to be successful. Series B investments are the order of the day when a company has a working prototype product and initial orders, as well as a more complete management team with diverse business skills. Series C investments are made when a company has more than one customer, working products, marketing and sales channels in place, and a growing pipeline of sales prospects. Pricing and gross profit margins on those sales are no longer mysteries, and working capital is needed mainly for components and support.

Series A funding is usually in relatively small amounts—there are often fewer than 10 people employed by the company, and the biggest expense is their salaries. Series B is typically much larger; not only is more money needed, but it's easier to get, because risk has decreased. By the time of series C, the dollar figures have increased again, to meet the heavy expenses of raw materials, components, and inventory; moreover, risk has decreased even further. The number of potential investors increases with each funding round, and each new investor at each round tends to commit more than the earlier-round investors did. These stages aren't haphazard. A start-up usually plans the different funding rounds right from the get-go—it hopes to increase its valuation between funding rounds and therefore to give up less of its equity per dollar of capital invested.

Most VC businesses are limited partnerships, in which well-heeled investors—large pension funds, university endowments, and wealthy individuals—agree to invest as limited partners. The funds are organized by experienced fund managers, also known as general partners. These managers decide how the funds are invested.

To use an example we will return to, the general partners might decide (as we did) to invest in a holographic-storage company for several reasons. The storage market promises long-term growth. The capacity per dollar is expected to increase by an order of magnitude over magnetic and optical technologies. And the risk-adjusted payoff is 10 times the initial committed capital in an acceptable time frame. Fund managers get where they are by demonstrating an ability to generate high returns, based on their track records in previous funds. Typical funds are organized for a finite life, often six or seven years, after which the fund is required to wind down operations—and distribute any proceeds to the limited partners.

Neither the limited nor the general partners welcome risk. Limited partners are looking for a higher rate of return than they could get in the stock market but with not much more uncertainty. And general partners are playing with other people's money. They hope that if they consistently hit the ball well, once in a while a home run will fly off their bats.

General partners are compensated in two ways. First, they receive management fees for running the fund, typically 2 percent of funds managed. So if a general partnership is managing a US $1 billion fund, it will receive $20 million in management fees, as well as reimbursements.

Second, the general partners receive a share of any profits after the limited partners are paid back their initial investments and their share of the profits. For example, if a $1 billion fund returns $5 billion after management fees and expenses are deducted, the limited partners receive their initial $1 billion plus 80 percent of $4 billion, for a total of $4.2 billion. Typically, the general partnership gets the other 20 percent of the $4 billion profit, or $800 million. This percentage is known as the general partner "carry," which is short for "carried interest." That's a pretty good paycheck to divide up among, say, 10 to 20 managing directors who might share in the carry.

And then there are the bargains struck by the "A-list" VCs, such as Kleiner Perkins Caufield & Byers, in Menlo Park, Calif., or Greylock Management Corp., in Waltham, Mass. These VCs add substantial prestige to start-ups, so they tend to see the hottest action. A-list VC firms get to charge more—3 percent management fees instead of 2 percent, and a 30 percent carry instead of 20 percent. It's no wonder you see so many Ferraris sitting in the parking lots on Menlo Park's Sand Hill Road, home base for the VCs of Silicon Valley.