Venture Capital
All successful enterprises are born from brilliant concepts, yet without substantial funds, even the most exceptional ideas remain stagnant. Adequate financial backing is essential for a fledgling business to transition from mere vision to tangible reality, with venture capital often serving as a lifeline for aspiring entrepreneurs in the early phases of development.
venture capital is typically provided to early-stage start-up companies that have high growth potential in industries such as biotechnology, information technology and manufacturing. Venture capital investments are generally made as cash investments in exchange for shares in the company.
What is Venture Capital?
Venture capital (VC) is a form of private equity that funds startups and early-stage emerging companies with little to no operating history but significant potential for growth. Fledgling companies sell ownership stakes to venture capital funds in return for financing, technical support and managerial expertise.
VC investors typically participate in management, and help the young company's executives make decisions to drive growth. Startup founders have deep expertise in their chosen line of business, but they may lack the skills and knowledge required to cultivate a growing company, while VCs specialize in guiding new companies.
Venture capital offers entrepreneurs other advantages. Portfolio companies get access to the VC fund's network of partners and experts. Moreover, they can depend on the VC firm for assistance when they try to raise more money in the future.
Venture capital is an alternative investment that's typically only available to institutional and accredited investors. Pension funds, big financial institutions, high-net-worth investors (HNWIs) and wealth managers typically invest in VC funds.
How Does Venture Capital Work?
Venture capital firms provide funding for new companies in the early stages of development.
There are four types of players in the venture capital industry:
- Entrepreneurs who start companies and need funding to realize their vision.
- Investors who are willing to take on significant risk to pursue high returns.
- Investment bankers who need companies to sell or take public.
- Venture capitalists who profit by creating markets for the entrepreneurs, investors and bankers.
Entrepreneurs looking for capital submit business plans to VC firms in the hope of obtaining funding. If the VC firm considers the business plan to be promising, it will conduct due diligence, which entails a deep dive into the business model, product, management, operating history and other areas pertinent to assessing the quality of the business and idea.
Regardless of how far along the business is, a VC firm also takes a deep look at the principals—everything from their education and professional experience to relevant personal details. Extensive due diligence is vital to making good investment decisions.
If the due diligence process is successful and the growth outlook for the business is promising, the VC firm will offer capital in exchange for an equity stake. Often, capital is provided in multiple rounds and the VC firm will take an active role in helping run the portfolio company.
Stages of Venture Capital Investing
As portfolio companies grow and evolve, they pass through different stages in the VC process. Some venture capital funds specialize in particular stages, while others may consider investing at any time.
- Seed round funding. This is the first round of VC funding, in which venture capitalists offer a small amount of capital to help a new company develop its business plan and create a minimum viable product (MVP).
- Early stage funding. Typically designated as series A, series B and series C rounds, early stage capital helps startups get through their first stage of growth. The funding amounts are greater than the seed round, as startup founders are ramping up their businesses.
- Late stage funding. Series D, series E and series F rounds are late-stage VC funding. At this point, startup companies should be generating revenue and demonstrating robust growth. While the company may not yet be profitable, the outlook is promising.
The VC firm's objective is to grow their portfolio companies to the point where they become attractive targets for acquisitions or IPOs. The venture capital firm aims to sell off its stakes at a profit and distribute the returns to its investors.
What Are Venture Capital Funds?
Like other types of private equity funds, venture capital funds are structured as limited partnerships. General partners (composed of the firm and its principals) manage the fund and serve as advisors to the fund's portfolio companies. Investors in the fund are limited partners.
Multiple venture capital funds may be housed under one VC firm. The fund then makes investments in a stable of promising companies.
The firm tends to take minority stakes of less than 50% in the fund's portfolio companies, with the goal of increasing their value. Exit strategies include selling the portfolio company to another public company or taking the portfolio company public. The VC firm can also sell shares in the portfolio company on the secondary market.
Venture capital funds generate revenue by charging management and performance fees. The most common fee structure is two and twenty: The VC firm charges its investors a management fee of 2% on total assets under management (AUM), plus a performance fee equal to 20% of profits.
Private Equity vs. Venture Capital
As noted above, venture capital is considered a form of private equity. The clearest difference between them is that venture capital supports entrepreneurial ventures and startups, while private equity tends to invest in established companies.
Venture Capital
- Invests in startups
- Typically acquires stakes that are less than 50% of a company's equity
- May participate in the management of portfolio companies
- Extremely popular in the tech sector
- Invests in companies that have yet to generate significant revenue or profits
- Generates a return when a portfolio company is sold or taken public
Private Equity
- Invests in established businesses, and often prefers financially distressed companies
- Takes a majority stake in portfolio companies
- Almost always participates actively in management and operation of portfolio companies
- Generates a return when the portfolio company is sold or taken public
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