Venture Capital

What is Venture Capital (VC) & How Does it Work?

What is Venture Capital(VC)?

Venture capital is a form of private equity and a type of funding given by investors to startups and small companies that are considered to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks, and other financial institutions. However, it does not always take the form of money; it can also be provided in the form of technical or managerial expertise. Venture capital is typically allocated to small companies with exceptional growth potential or to companies that have grown rapidly and appear to be poised to continue to expand.

Venture Capital investment is also referred to as risk capital or patient venture capital because it entails the possibility of losing money if the venture is unsuccessful and it takes a medium to a long time for the investments to yield results.

Features of Venture Capital Investments

  • Long term horizon
  • Equity participation and capital gains
  • Venture capital investments are made in innovative projects
  • High Risk
  • Suppliers of venture capital participate in the management of the company
  • Lack of Liquidity

Examples of Venture Capital Firms

Sequoia Capital

The venture capital firm has invested in companies like Uber, Bird, DoorDash, and 23andMe.

Andreessen Horowitz

The venture capital firm has invested in companies like Lime, Airbnb, Instacart, and Foursquare.

What is a venture capitalist?

Investors working with a venture capital company are called venture capitalists.

Not to be confused with an angel investor, a wealthy individual who is investing his own money in promising companies, a venture capitalist is raising and investing capital from limited partners. Mark Cuban and Lori Greiner, frequent investors in ABC’s Shark Tank, are examples of angel investors.

Methods of Venture Capital Financing

  • Equity
  • Participating debentures
  • Conditional loan

The Venture Capital Funding Process

In order to raise the money needed to invest in companies, venture capital firms open up a fund and ask limited partners for commitments. This process allows them to form a pool of money, which is then invested in promising private companies. The investments they make are typically in exchange for minority equity — which is 50% or less of the company’s shares.

When companies expand, they move through the various stages of venture capital. In addition, firms or investors may specifically focus on certain phases — which impact how they invest.

Seed Stage

When a venture capitalist provides a fairly small amount of capital for an early-stage company to be used for product development, market research, or business plan growth, it is called a seed round. As their name suggests, a seed round is often the first official funding round for the company. Convertible notes, equity, or preferred stock options are usually issued to seed round investors in return for their investment.

Early Stage

The early stage of the funding of venture capital is intended for companies in the development phase. This funding stage is typically greater in amount than the seed stage, because new companies require more capital to start operations until they have a viable product or service. Venture capital is invested by letters in rounds or series: Series A, Series B, Series C, and so on.

Later Stage

The later stage of venture capital investment is for more mature companies that may or may not yet be profitable but that have proven growth and generate revenue. As in the early stage, a letter designates each round or series.

When a company in which a VC firm has invested is acquired successfully or becomes public, the firm makes a profit and distributes returns to the limited partners that have invested in its fund. The company might also make a profit by selling some of its stock in what’s called the secondary market to another investor.

Exit Route

There are different exit options for Venture Capital to cash out their investment:

  • IPO
  • Promoter buyback
  • Mergers & Acquisitions
  • Sale to another strategic investor

Advantages of Venture Capital

  • A large amount of equity finance can be provided.
  • They bring wealth and expertise to the company.
  • The company does not have an obligation to repay the money.
  • It provides valuable information, resources, and technical assistance to make a successful business.

Disadvantages of Venture Capital

  • It’s a long and complex process.
  • It’s an uncertain form of financing.
  • The benefits of such financing can only be realized in the long run.

See Also
Things you need to do before starting your business
What is an LTD Company?