Venture capital is a type of financing used by small and medium-sized businesses. Because these companies are early in their development cycle, they are riskier investments, leaving them unable to get traditional financing from banks. Although venture capital is a relatively small fraction of global corporate investments, it has contributed to an amazing amount of economic growth, facilitating the emergence of companies such as Microsoft, Google, and Yahoo. Venture capital is usually invested in return for equity (shares) in the company rather than fixed debt, as to account for the greater risk these investments represent. Venture capital is usually invested with a three-to-seven-year perspective. Failure rates can vary anywhere from 20 to 90 percent of the portfolio, and expected returns are between 30 to 100 percent (to offset for failures within the portfolio).
Venture capital has the advantage of being available for risky and new businesses as well as providing access to venture capitalists, who are usually industry experts able to supply valuable insight to the companies they invest in. Nonetheless, obtaining venture capital implies a certain loss of control in management decisions, and can be quite costly in terms of administrative costs and time. Venture capital fills an important gap in the financing cycle, enabling the growth of high-risk companies.
There are five main types of venture capital adapted to different companies. A smaller venture capital investment is called seed capital, and is used by companies to create a prototype and fund basic market research. Start-up capital is used to fund recruitment of key management as well as finalizing the product for commercialization. Early stage capital is used to increase productivity and increase company efficiency, while expansion capital is used to enter new markets. The last stage of venture capital, late stage capital, is used to increase capacity and marketing, while preparing for the exit of the venture capital.
Venture capital can be obtained through two different processes. Some companies will negotiate milestone-type financing, where the next amount of financing will be made available once it reaches predetermined goals. For example, a company could link milestones to sales: once a sales target is reached, the venture capital would be released. The advantage is that the company can raise great amounts of capital upfront, leaving less pressure in the future to secure more funding. Other companies prefer seeking venture capital in the form of financing rounds, entering a new financing round after certain internal goals are met. In these cases, venture capital firms who have already invested in these companies usually require a right of first say, so they can be the first company to evaluate the potential investment and decide if they want to invest in the next round. The advantage is that financing terms are advantageous when negotiated as the company progresses. As the product is more successful, there is less risk for the investor, and the company can divest less equity, or give up less control than if it had negotiated the financing up front.
The venture capital investment usually takes the form of equity in ordinary shares, but can take many other forms. Financing is usually based on company effort, venture capitalist effort, venture capitalist preference, and feasibility of the underlying technology. The three main structures of venture capital investments are ordinary shares, preferred shares, and debt. Ordinary shares are cheaper for the company to finance in the short term, and profit expectations can be quite elevated for the investor, but usually imply a loss of control for the company (due to the emission of voting shares). Preferred shares have priority over ordinary shares in case of bankruptcy and usually have fixed dividends, but do not always carry a voting right. Finally, debt is usually secured against existing assets, and requires fixed repayment; this is also called venture debt.
Once a venture capitalist has made an investment, he or she can establish two types of relationships with the company. Some venture capitalists take a hands-off approach, leaving the management in charge of the raised funds; these are called silent partners, as the company is not allowed to disclose the name of the new investor. Others will prefer a more hands-on approach, supervising through a seat on the board of directors, sharing their expertise to increase the possibility of success.
Advantages And Disadvantages
The main advantage of venture capital is accessibility to liquidity, as traditional lenders (such as banks) usually do not provide funds to young, unproven companies. Without assets or sales, growing companies need access to investors to take them to the next stage of growth. Venture capital fulfills that role. The other advantage is that having venture capital translates into access to the expertise and networks belonging to venture capitalists. These investors have a vested interest in the success of the company, and can often supply expertise in recruiting the management team and the board of directors, as well as assisting in obtaining additional financing.
Venture capital imposes some constraints on the organization; as the company gives shares in exchange for liquidity, there is a loss of control in management decision making. For example, some investors will take a hands-on approach, requiring a seat on the board of directors so they can keep an eye on their investment. Some go as far as requiring a veto on major decisions as a condition for investing. This can effectively restrict the decision capacity of the current management. Getting venture capital also requires considerable investment in terms of time and money; from presentation to negotiation to signature, it is not uncommon for the process to take between three to six months. Finally, between 5 percent and 10 percent of the amount raised is often used to pay legal and investment fees.
Venture Capital Firms
Many venture capital firms are limited partnerships with a pool of investment capital; they invest the capital in selected companies under the guise of a portfolio. Venture capital firms can have portfolios ranging from the low millions up to billions of dollars. Most venture capital firms enter an investment with a perspective of three to seven years. After this period, venture capitalists usually try to exercise their exit strategy. Traditional exits include IPO (initial public offering, or being listed on the stock market), sale of equity to another company, or repurchase by management.
Venture capital firms fill an important gap in the financing chain. They are able to finance businesses that cannot rely on government subsidies, but which are still too risky for banks. As such, venture capital is an important actor to finance innovation, enabling the introduction of new products and processes to the market. Also, by their unique position in the financing chain, these firms are often essential to commercializing inventions generated by private and public research institutions.
- Franklin Allen and Wei-ling Song, “Venture Capital and Corporate Governance” (Wharton Financial Institutions Center, Drexel University, September 29, 2002);
- Laura Bottazzi, Marco Da Rin, and Thomas Hellmann, “Who Are the Active Investors? Evidence From Venture Capital,” Journal of Financial Economics (September 2007);
- Astrid Romain and Bruno Van Pottelsberghe, “The Economic Impact of Venture Capital,” Discussion Paper Series 1: Studies of the Economic Research Centre, Deutsche Bundesbank (n.18, 2004).
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