What Is Venture Capital?
Venture Capital (VC) is a private form of financing provided by investors to small businesses or startups for the development of the business with outstanding growth potential. The capital invested is from venture capital funds, well-off individual, investment banks and other financial institutions.
Venture Capitals, do not only provide money. They also provide their management expertise and technical support necessary to scale. However, it is important to note that the goal of a Venture Capital is to make a good return for invested funds. Though risky – with a nine out of 10 fail rate – the potential for above-average profit is an attractive payoff to investors.
For this reason, Venture Capitals seek to invest only in businesses or startups that have the potential to generate 10x type of return. This enables them to even out the losses of other companies they may have within their investment portfolio.
How Does Venture Capital Work?
There are two key things you need to understand about Venture Capital Funds: general and limited partners. General partners are in charge of making investment decisions such as finding startups to invest in. While the limited partners provide the funds necessary to complete those investments.
It is important to note that Venture Capital funds don’t invest the money of their partners, and if they do, it accounts for less than 1% of the size of the fund. Hence, all the money invested originates from limited partners such as one-percenters, pension funds, hedge funds and more.
How Do Venture Capital Firms Make Money?
Venture Capital funds make their money in two ways: management fees and carried interest.
Management fees can be defined as the cost associated with having your assets professionally managed. Which is the amount of capital that is under management. Venture Capital Funds typically charge an annual management fee to fund’s management company, as a form of salary. The fee is used to cover expenses and fund expenses. Management fees are usually calculated on a percentage of capital commitments to the fund, typically 2 % to 2.5%.
On the other hand is carried interest, which is basically a share of the profit of an investment or investment fund that is paid to the investment manager over the amount that the manager contributed to the partnership. Normally, carried interest in Venture Capital is about 20% to 25%, whereby 20% of the profit goes to the general partners and 80% belongs to the limited partners.
How Does This Influence Start-Ups?
Any investor will back a start-up with only one goal in mind which is to generate a return on investment. In short, they are in for the money – about 99% of the time. Hence, it is worthwhile to note that how VC firms influence start-ups.
Venture Capital funds tend to have a fixed investment life of about 10 years. Hence, VCs like to establish shorter investment cycles in which they can sell their position within this time before they run out of money or energy. If a company fails to provide an exit, the VC firm will move in to work alongside the founders to scale and seek an exit, providing the returns they initially sought.
See also: 4 Ways Financial Planning Differs for Entrepreneurs
What Are the Different Types of Venture Capital?
There are six types of venture capital based on the stage of the business. However, there are only three principal types of venture capital: early stage, expansion and acquisition or buyout financing.
Early Stage Financing
Early State financing is done by angel investors, often a wealthy individual with technical knowledge can make a small investment at a very early stage of a company’s development. The early-stage financing can be divided into three main subdivisions: seed financing, start-up financing and first stage financing.
- Seed-stage financing. This takes the form of financing of projects within their initial phase. It seeks to cover the expenses of the new venture including expenses for research and development of the project idea.
- Start-up financing. Finances projects that are in the phase of testing and finalising the production prototype. At this stage, the project may only have one principal working full-time and is in the process of getting other team members.
- First-stage financing. At this stage, the project is fully launched and the company may be about 2-3 years old at this point. The funding acquired goes towards boosting sales, increasing productivity and building corporate infrastructure and distribution systems.
Expansion Financing
Most Venture Capital funds, invest at this stage to maximize return on investment. The financing takes the form of second-stage financing and bridge financing (also known as third-stage or mezzanine financing).
- Second-stage financing. The company is seeking to expand in all its forms. Sales at this stage of the company are snowballing. Thus the company is looking to increase the marketing budget to enter new markets.
- Bridge or Mezzanine financing. The financing at this stage is used to prepare a company for an Initial Public Offering (IPO). The company has proven itself as a viable business and is ready to move to the next stage. This form of financing is usually short-term and is typically paid back from the proceeds of the IPO.
Acquisition/Buyout Financing
A strategic form of venture capital financing that seeks to fund a company to acquire or buy out a competitor or a strategic business whose success may drive revenue growth for the company and Venture Capital.
Advantages & Disadvantages of Venture Capital Funding
There are several advantages and disadvantages of using venture capital to finance your business or start-up that you need to note.
Advantages
a. Business Expertise. Venture capital funds also provide young businesses with a valuable source of guidance and business expertise to push them to the next level. They can be a great source of help when making business decisions. Particularly in key areas of growth such as financial and human resource management.
b. Access to More Resources. Venture capital firms can provide active support and resources that are key for your particular stage in the growth of your young company. They can provide active support and resources for legal, tax, personnel matters and more.
c. Networking & Connections. Typically, venture capital firms are very well connected in the business community. Therefore, as part of the firm, you can tap into those connections and benefit tremendously.
Disadvantages
a. Loss of Control. Along with the capital injection, venture capital firms seek to get involved in your business. The size of their stake will determine how much say they may have to shape the future of the company.
b. Minority Ownership Status. Depending on the stake the venture capital firm is seeking to have, you end up with a minority stake. As a result, you lose management control of your company.
Learn More: 8 Personal Finance Tips for Start-up Entrepreneurs
In a SnapShot
Venture capital funds inject funds into new high-risk and profitable businesses intending to make 10x profit for their investors. This makes venture capitals a fundamental force that drives innovation as the majority of the start-ups that are recipients of the fund are into software, telecommunication, biotech, renewable energy and internet.
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