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Venture capital is a form of private equity and financing that is provided to startups and small businesses as a way of investing in their growth potential. A venture capitalist is someone who provides equity to a venture capital fund, and are usually wealthy individual investors, although funds can also come from businesses such as banks or other financial institutions. However, venture capital does not always have to be monetary and can take the form of experience or technical expertise in a specific field.
Venture capital is of particular interest to small businesses as it can enable rapid growth and expansion at a time when it can be otherwise difficult to grow.
The venture capital industry evolved at the end of the Second World War when it was used to boost businesses with the potential to rebuild specific sectors, evolving into one of the most exciting and profitable forms of investment. It plays a key role in driving growth as well as inspiring innovation.
Venture capital works by raising funds, either from individuals or organizations, and then identifying businesses that have demonstrated a potential for growth or value. Depending on the fund, venture capital is invested at several stages in the business lifecycle. For example, seed-stage venture capitalists invest to help new businesses get off the ground. Late-stage venture capital is invested to help established companies continue to expand. Some venture capital firms invest across a range of industries while others prefer to invest within a particular vertical.
As well as investing funds, VCs can also add value to a business by providing experience and technical knowledge that can be of enormous benefit. For example, VC’s can provide a valuable network of connections, can aid in the strategic decision-making process, or even participate at board level.
To ensure a return on their investment, venture capital firms usually identify an exit strategy, such as an initial public offering, acquisitions, or buybacks.
Venture capitalists (VC’s), who are the driving force behind venture capital, are individuals or businesses looking to discover opportunities that have potential for extraordinary growth or an ability to open new markets. They also want to make a significant return on their investment. As such, they are looking for businesses that can demonstrate the following criteria:
Should a business meet all of the above, they may be a potential candidate for a venture capital investment – if they can connect with the right investors.
Small businesses and startups who want to make the right connections, and generally become more attractive to VCs can make themselves more visible in the following ways:
Venture capital investment and support can have huge potential benefits for small businesses looking to progress to the next level. However, it can also come with some challenges.
The advantages of venture capital include:
Some of the challenges of venture capital investment include:
As mentioned above, there are several stages of the venture capital investing process where funds can identify opportunities. These include:
What constitutes a venture capital fund? This is essentially a pool of small business funding that is accumulated from investors looking for opportunities to finance early-stage companies. They generally focus on companies that have a high long-term growth potential but need financial backing to drive their development.
Venture capital funds are made up of limited partners (LPs) and general partners (GPs). Limited partners constitute the core of most venture capital funds. These are the individuals or organizations who invest their time and money into the fund and recipient businesses. The general partner is a legal entity, usually established by the fund and employed to manage the overall partnership.
A venture capital fund has a specific lifecycle, running from fund establishment to investment and finally to an exit strategy, although this may be repeated multiple times across various investments.
The fund operates using a system called a capital call, also known as a drawdown, which occurs when funds need to be collected from limited partners. When an investor buys into a fund, they make an agreement that funds will be available when requested.
When an investment then makes a profit, usually when it exits a position, there are several ways these funds can be distributed amongst partners. In many firms, 80% of the profit is shared amongst the LPs and 20% goes to the GPs.
There are also various sources of funds for venture capitals. For example, they can come from high-net-worth individuals, pension funds, endowments, and other similar financial institutions. Funds generally charge investors a fee of 2% per annum to manage the fund, with 20% of the profits also going to the GPs, as stated above.
Although venture capital firms are similar to angel investors, they are not the same. Venture capitalists invest money that is being controlled by a capital fund or firm, whereas angel investors are usually individuals investing their own money. However, both can bring expertise and support in return for a share in the business.
Businesses seek funding from venture capital for a number of key reasons. The benefits of venture capital can include:
However, there are some potential challenges of venture capital, including:
Not all businesses align with the venture capital growth model. It is also essential that businesses take the time to determine whether they can achieve the rapid scale and exit that venture capitalist’s desire. You need to consider the following:
Venture capital firms are similar in some ways to private equity investors. However, there are some key differences between private equity and venture capital firms that draw a distinction between the two. For example, VCs typically focus on early-stage, high-growth companies, while private equity is generally more focused on mature companies.
There is also usually a variance in the typical size of investments. Private equity firms usually make much larger investments, often of $100m or more. Venture capital funds invest at lower levels, typically $10m or less as they are usually dealing with startups or smaller businesses.
The degree to which each type of investor gets involved in the daily operations of the portfolio company also differs, with VCs usually taking a more hands-on approach and offering support and expertise to encourage growth. Private equity is usually more of a hands-off approach.
The risk profile also differs, with private equity usually being invested in more established and stable businesses with a lower degree of risk. However, it is precisely the higher risk, with more potential for reward, that is appealing to VC investors.
In terms of time frames, VCs might aim for a faster exit through either an IPO or acquisition. Private equity investments are generally made over a longer time scale. The equity position is also different, with VCs typically buying 50% or less of portfolio businesses while private equity firms usually prefer to acquire the entire operation. To learn more about different ways to get funding, check out how to apply for a small business loan.
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