What is ‘Venture Capital’
Venture capital is financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. For startups without access to capital markets, venture capital is an essential source of money. Risk is typically high for investors, but the downside for the startup is that these venture capitalists usually get a say in company decisions.
BREAKING DOWN ‘Venture Capital’
Venture capital generally comes from well-off investors, investment banks and any other financial institutions that pool similar partnerships or investments.
Though providing venture capital can be risky for the investors who put up the funds, the potential for above-average returns is an attractive payoff. Venture capital does not always take a monetary form; it can be provided in the form of technical or managerial expertise. For new companies or startup ventures that have a limited operating history, venture capital funding is increasingly becoming a popular capital raising source, as funding through loans or other debt instruments is not readily available.
Angel Investors and Venture Capital Firms
For small businesses, or for up-and-coming businesses in emerging industries, venture capital is generally provided by high net worth individuals (HNWIs) – also known as ‘angel investors’ – and venture capital firms. The National Venture Capital Association (NVCA) is an organization composed of hundreds of venture capital firms that offer funding to innovative and entrepreneurial ventures.
Angel investors are typically a diverse group of individuals who gained their wealth through a variety of sources. However, the majority are usually entrepreneurs themselves, or are executives who retired early from previous ventures that developed into successful empires.
Self-made investors providing venture capital typically share several key characteristics. The majority look to invest in companies that are well managed, have a fully-developed business plan and are poised for substantial growth. These investors are also likely to offer funding to ventures that are involved in the same or similar industries or specialties with which they are familiar. Another common occurrence among angel investors is co-investing, where one angel investor funds a venture alongside a trusted friend or associate, often another angel investor.
The Venture Capital Process
The first step for any business looking for venture capital is to submit a business plan, either to a venture capital firm, or to an angel investor. If interested in the proposal, the firm or the investor must then perform due diligence, which includes a thorough investigation of the business model, products, management and operating history, among other things. Once due diligence has been completed, the firm or the investor will pledge an investment in exchange for equity in the company. The firm or investor then takes an active role in the funded company. Because capital is typically provided in rounds, the firm or investor actively ensures the venture is meeting certain milestones before receiving another round of capital. The investor then exits the company after a period of time, typically 4 to 6 years after the initial investment, through a merger, acquisition or initial public offering (IPO).