Venture capital is a type of equity financing that addresses
the funding needs of entrepreneurial companies that for reasons of size,
assets, and stage of development cannot seek capital from more traditional
sources, such as public markets and banks. Venture capital investments are
generally made as cash in exchange for shares and an active role in the
invested company.
Venture capital differs from traditional financing sources
in that venture capital typically:
Focuses on young, high-growth companies
Invests equity capital, rather than debt
Takes higher risks in exchange for potential higher returns
Has a longer investment horizon than traditional financing
Actively monitors portfolio companies via board
participation, strategic marketing, governance, and capital structure
Successful long-term growth for most businesses is dependent
upon the availability of equity capital. Lenders generally require some equity
cushion or security (collateral) before they will lend to a small business. A
lack of equity limits the debt financing available to businesses. Additionally,
debt financing requires the ability to service the debt through current
interest payments. These funds are then not available to grow the business.
Venture capital provides businesses a financial cushion.
However, equity providers have the last call against the company’s assets. In
view of this lower priority and the usual lack of a current pay requirement,
equity providers require a higher rate of return/return on investment (ROI)
than lenders receive.
Understanding Venture Capital
Venture capital for new and emerging businesses typically
comes from high net worth individuals (“angel investors”) and venture capital
firms. These investors usually provide capital unsecured by assets to young,
private companies with the potential for rapid growth. This type of investing
inherently carries a high degree of risk. But venture capital is long-term or
“patient capital” that allows companies the time to mature into profitable
organizations.
Venture capital is also an active rather than passive form
of financing. These investors seek to add value, in addition to capital, to the
companies in which they invest in an effort to help them grow and achieve a
greater return on the investment. This requires active involvement; almost all
venture capitalists will, at a minimum, want a seat on the board of directors.
Although investors are committed to a company for the long
haul, that does not mean indefinitely. The primary objective of equity
investors is to achieve a superior rate of return through the eventual and
timely disposal of investments. A good investor will be considering potential
exit strategies from the time the investment is first presented and
investigated.
Angel Investors
Business “angels” are high net worth individual investors
who seek high returns through private investments in start-up companies.
Private investors generally are a diverse and dispersed population who made
their wealth through a variety of sources. But the typical business angels are
often former entrepreneurs or executives who cashed out and retired early from
ventures that they started and grew into successful businesses.
These self-made investors share many common characteristics:
They seek companies with high growth potentials, strong
management teams, and solid business plans to aid the angels in assessing the
company’s value. (Many seed or start ups may not have a fully developed
management team, but have identified key positions.)
They typically invest in ventures involved in industries or
technologies with which they are personally familiar.
They often co-invest with trusted friends and business
associates. In these situations, there is usually one influential lead investor
(“archangel”) those judgment is trusted by the rest of the group of angels.
Because of their business experience, many angels invest
more than their money. They also seek active involvement in the business, such
as consulting and mentoring the entrepreneur. They often take bigger risks or
accept lower rewards when they are attracted to the non-financial
characteristics of an entrepreneur’s proposal.
Equity capital or financing is money raised by a business in
exchange for a share of ownership in the company. Ownership is represented by
owning shares of stock outright or having the right to convert other financial
instruments into stock of that private company. Two key sources of equity
capital for new and emerging businesses are angel investors and venture capital
firms.
Typically, angel capital and venture capital investors
provide capital unsecured by assets to young, private companies with the potential
for rapid growth. Such investing covers most industries and is appropriate for
businesses through the range of developmental stages. Investing in new or very
early companies inherently carries a high degree of risk. But venture capital
is long term or “patient capital” that allows companies the time to mature into
profitable organizations.
Angel and venture capital is also an active rather than
passive form of financing. These investors seek to add value, in addition to
capital, to the companies in which they invest in an effort to help them grow
and achieve a greater return on the investment. This requires active
involvement and almost all venture capitalists will, at a minimum, want a seat
on the board of directors.
Although investors are committed to a company for the long
haul, that does not mean indefinitely. The primary objective of equity
investors is to achieve a superior rate of return through the eventual and
timely disposal of investments. A good investor will be considering potential
exit strategies from the time the investment is first presented and
investigated.
The Venture Capital Process
A startup or high growth technology companies looking for
venture capital typically can expect the following process:
Submit Business Plan. The venture fund reviews an
entrepreneur’s business plan, and talks to the business if it meets the fund’s
investment criteria. Most funds concentrate on an industry, geographic area,
and/or stage of development (e.g., Start-up/Seed, Early, Expansion, and Later).
Due Diligence. If the venture fund is interested in the
prospective investment, it performs due diligence on the small business,
including looking in great detail at the company’s management team, market,
products and services, operating history, corporate governance documents, and
financial statements. This step can include developing a term sheet describing
the terms and conditions under which the fund would make an investment.
Investment. If at the completion of due diligence the
venture fund remains interested, an investment is made in the company in
exchange for some of its equity and/or debt. The terms of an investment are
usually based on company performance, which help provide benefits to the small
business while minimizing risks for the venture fund.
Execution with VC Support. Once a venture fund has invested,
it becomes actively involved in the company. Venture funds normally do not make
their entire investment in a company at once, but in “rounds.” As the company
meets previously-agreed milestones, further rounds of financing are made
available, with adjustments in price as the company executes its plan.
Exit. While venture funds have longer investment horizons
than traditional financing sources, they clearly expect to “exit” the company
(on average, four to six years after an initial investment), which is generally
how they make money. Exits are normally performed via mergers, acquisitions,
and IPOs (Initial Public Offerings). In many cases, venture funds will help the
company exit through their business networks and experience.
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