Venture capital (VC) is financial capital provided to early-stage, high-potential, high risk, growth startup companies. The venture capital fund makes money by owning equity in the companies it invests in, which usually have a novel technology or business model in high technology industries, such as biotechnology, IT, software, etc. The typical venture capital investment occurs after the seed funding round as growth funding round (also referred as Series A round) in the interest of generating a return through an eventual realization event, such as an IPO or trade sale of the company. It is important to note that venture capital is a subset of private equity. Therefore all venture capital is private equity, but not all private equity is venture capital.
In addition to angel investing and other seed funding options, venture capital is attractive for new companies with limited operating history that are too small to raise capital in the public markets and have not reached the point where they are able to secure a bank loan or complete a debt offering. In exchange for the high risk that venture capitalists assume by investing in smaller and less mature companies, venture capitalists usually get significant control over company decisions, in addition to a significant portion of the company’s ownership (and consequently value).
Venture capital is also associated with job creation (accounting for 21% of US GDP), the knowledge economy, and used as a proxy measure of innovation within an economic sector or geography. Every year there are nearly 2 million businesses created in the USA, and only 600-800 get venture capital funding. According to the National Venture Capital Association 11% of private sector jobs come from venture backed companies and venture backed revenue accounts for 21% of US GDP.
Funding
Venture capitalists are typically very selective in deciding what to invest in; as a rule of thumb, a fund may invest in one in four hundred opportunities presented to it. Funds are most interested in ventures with exceptionally high growth potential, as only such opportunities are likely capable of providing the financial returns and successful exit event within the required timeframe (typically 3–7 years) that venture capitalists expect.
Young companies wishing to raise venture capital require a combination of extremely rare, yet sought after, qualities, such as innovative technology, potential for rapid growth, a well-developed business model, and an impressive management team. VCs typically reject 98% of opportunities presented to them, reflecting the rarity of this combination.
Because investments are illiquid and require 3–7 years to harvest, venture capitalists are expected to carry out detailed due diligence prior to investment. Venture capitalists also are expected to nurture the companies in which they invest, in order to increase the likelihood of reaching an IPO stage when valuations are favorable. Venture capitalists typically assist at four stages in the company’s development
- Idea generation;
- Start-up;
- Ramp up; and
- Exit
Because there are no public exchanges listing their securities, private companies meet venture capital firms and other private equity investors in several ways, including warm referrals from the investors’ trusted sources and other business contacts; investor conferences and symposia; and summits where companies pitch directly to investor groups in face-to-face meetings, including a variant known as "Speed Venturing", which is akin to speed-dating for capital, where the investor decides within 10 minutes whether s/he wants a follow-up meeting. In addition there are some new private online networks that are emerging to provide additional opportunities to meet investors.
This need for high returns makes venture funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. That is most commonly the case for intangible assets such as software, and other intellectual property, whose value is unproven. In turn this explains why venture capital is most prevalent in the fast-growing technology and life sciences or biotechnology fields.
If a company does have the qualities venture capitalists seek including a solid business plan, a good management team, investment and passion from the founders, a good potential to exit the investment before the end of their funding cycle, and target minimum returns in excess of 40% per year, it will find it easier to raise venture capital.
Financing stages
There are typically six stages of venture round financing offered in Venture Capital, that roughly correspond to these stages of a company’s development.
- Seed Money: Low level financing needed to prove a new idea (Often provided by "angel investors")
- Start-up: Early stage firms that need funding for expenses associated with marketing and product development
- First-Round (Series A round): Early sales and manufacturing funds
- Second-Round: Working capital for early stage companies that are selling product, but not yet turning a profit
- Third-Round: Also called Mezzanine financing, this is expansion money for a newly profitable company
- Fourth-Round: Also called bridge financing, 4th round is intended to finance the "going public" process
Between the first round and the fourth round, venture backed companies may also seek to take "venture debt".