A person who makes these investments is known as a venture capitalist. Technically, venture capital is a type of private equity PE. But usually the term 'private equity' is used to mean investments made into more mature businesses by PE firms.
We explain what private equity is and the differences between PE and VC in our blog post, What is private equity finance and how does it work? Unlike angel investors who use their own money to invest, venture capitalists most commonly work for venture capital firms which raise funds from outside investors.
These investors, known as limited partners, can include high net worth individuals, family offices, and institutional investors such as pension funds and insurance companies. VCs use the capital they raise to invest in businesses with high growth potential or businesses that have already demonstrated impressive growth.
Some VC firms have a diversified approach and invest in companies at various stages of the business lifecycle, while others focus specifically on certain stages. For example, seed stage investors help early-stage start-ups get off the ground, while late stage investors help established companies continue their expansion. Many VC firms also specialise in making investments within a particular industry or industry vertical.
With VC financing, businesses can often obtain large amounts of capital. In addition to this, the right investor adds value to the company by providing skills, experience, and connections. VCs are best known for financing technology companies because of their tendency to scale easily, but they invest in non-tech businesses too.
These are a few things investors look for when evaluating a business:. They spend time vetting entrepreneurs and startup companies to seek out promising deals. Then, these deals are packaged into a venture capital fund, which VC firms market to limited partners to raise capital commitments.
VC firms supply funding and guidance to entrepreneurs to help their businesses succeed. They also stay in touch with investment bankers to assess potential exit options. During the venture capital process, many startups navigate through multiple stages or rounds of financing, including:. Seed: During this very early stage of development, entrepreneurs flesh out their business plan and often use seed capital for research and development to determine their product offering, target market and business strategy.
Angel investors tend to be more involved here. Early: As the business moves to scale production, operations and marketing, it can raise its first round of funding, called Series A.
As the business grows and expands, successive rounds Series B, C may follow. While VC firms compete to gain access to the best deals, they also support one another by investing together. Typically, several VC firms participate in each round of investment, with one firm serving as the lead investor and the others as secondary investors.
This helps to enhance the credibility of the startup business and also spreads work and risk across various firms. Typically, the limited partners of VC firms are institutional investors such as foundations and endowments, insurance companies and pension funds or family offices.
The minimum investment and qualifications required differ with each venture capital fund offering. You can check with your brokerage firm or financial advisor to see what venture capital options are available on their platform.
With the popularity of venture capital investing, other avenues such as crowdfunding platforms have opened up that allow both accredited and nonaccredited investors to gain access to venture capital funds and investments. According to Pitchbook. There are many reasons why investors are attracted to the venture capital industry.
As with many investments, the higher the risk, the higher the reward. This rings true when it comes to venture capital. The earlier the stage of investment, the higher the risk and return. The more money they manage, the less time they have to nurture and advise entrepreneurs. The fund makes investments over the course of the first two or three years, and any investment is active for up to five years.
The fund harvests the returns over the last two to three years. However, both the size of the typical fund and the amount of money managed per partner have changed dramatically. That left a lot of time for the venture capital partners to work directly with the companies, bringing their experience and industry expertise to bear.
Today the average fund is ten times larger, and each partner manages two to five times as many investments. Not surprisingly, then, the partners are usually far less knowledgeable about the industry and the technology than the entrepreneurs.
Even though the structure of venture capital deals seems to put entrepreneurs at a steep disadvantage, they continue to submit far more plans than actually get funded, typically by a ratio of more than ten to one. Why do seemingly bright and capable people seek such high-cost capital? Despite the high risk of failure in new ventures, engineers and businesspeople leave their jobs because they are unable or unwilling to perceive how risky a start-up can be.
Their situation may be compared to that of hopeful high school basketball players, devoting hours to their sport despite the overwhelming odds against turning professional and earning million-dollar incomes.
Consider the options. Entrepreneurs—and their friends and families—usually lack the funds to finance the opportunity. Many entrepreneurs also recognize the risks in starting their own businesses, so they shy away from using their own money. Some also recognize that they do not possess all the talent and skills required to grow and run a successful business. Most of the entrepreneurs and management teams that start new companies come from corporations or, more recently, universities.
This is logical because nearly all basic research money, and therefore invention, comes from corporate or government funding. The VC has no such caps. The venture model provides an engine for commercializing technologies that formerly lay dormant in corporations and in the halls of academia. Compensation typically comes in the form of status and promotion, not money.
It would be an organizational and compensation nightmare for companies to try to duplicate the venture capital strategy. Furthermore, companies typically invest in and protect their existing market positions; they tend to fund only those ideas that are central to their strategies. The result is a reservoir of talent and new ideas, which creates the pool for new ventures.
For its part, the government provides two incentives to develop and commercialize new technology. The first is the patent and trademark system, which provides monopolies for inventive products in return for full disclosure of the technology. That, in turn, provides a base for future technology development. Such seed funding is expected to create jobs and boost the economy. Although many universities bemoan the fact that some professors are getting rich from their research, remember that most of the research is funded by the government.
The newest funding source for entrepreneurs are so-called angels, wealthy individuals who typically contribute seed capital, advice, and support for businesses in which they themselves are experienced.
Turning to angels may be an excellent strategy, particularly for businesses in industries that are not currently in favor among the venture community. But for angels, these investments are a sideline, not a primary business. Downsizing and reengineering have shattered the historical security of corporate employment. The corporation has shown employees its version of loyalty.
Good employees today recognize the inherent insecurity of their positions and, in return, have little loyalty themselves. Additionally, the United States is unique in its willingness to embrace risk-taking and entrepreneurship. Unlike many Far Eastern and European cultures, the culture of the United States attaches little, if any, stigma to trying and failing in a new enterprise.
Leaving and returning to a corporation is often rewarded. For all these reasons, venture capital is an attractive deal for entrepreneurs. Those who lack new ideas, funds, skills, or tolerance for risk to start something alone may be quite willing to be hired into a well-funded and supported venture.
Corporate and academic training provides many of the technological and business skills necessary for the task while venture capital contributes both the financing and an economic reward structure well beyond what corporations or universities afford.
Even if a founder is ultimately demoted as the company grows, he or she can still get rich because the value of the stock will far outweigh the value of any forgone salary. By understanding how venture capital actually works, astute entrepreneurs can mitigate their risks and increase their potential rewards. Many entrepreneurs make the mistake of thinking that venture capitalists are looking for good ideas when, in fact, they are looking for good managers in particular industry segments.
The value of any individual to a VC is thus a function of the following conditions:. Entrepreneurs who satisfy these conditions come to the table with a strong negotiating position. The ideal candidate will also have a business track record, preferably in a prior successful IPO, that makes the VC comfortable. His reputation will be such that the investment in him will be seen as a prudent risk.
VCs want to invest in proven, successful people. Just like VCs, entrepreneurs need to make their own assessments of the industry fundamentals, the skills and funding needed, and the probability of success over a reasonably short time frame.
Many excellent entrepreneurs are frustrated by what they see as an unfair deal process and equity position. The VCs are usually in the position of power by being the only source of capital and by having the ability to influence the network.
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