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Every great business starts with a great idea, but even the best ideas don’t go far without money. It takes sufficient funding to take a startup from vision to execution, and for many entrepreneurs, venture capital provides critical financial support in the early stages of growth.
What is venture capital?
Venture capital (VC) is a form of private equity that funds startups and emerging start-up companies with little or no operating history but significant growth potential. Start-ups sell stakes to venture capital funds in exchange for financing, technical support and managerial expertise.
Venture capitalists usually participate in the management and help the leaders of the young company make decisions to stimulate growth. Startup founders have deep expertise in their chosen industry, but they may lack the skills and knowledge to build a growing business, while VCs specialize in nurturing new businesses.
Venture capital offers entrepreneurs other advantages. Portfolio companies have access to the venture capital fund’s network of partners and experts. Moreover, they can count on the help of the venture capitalist when they try to raise more money in the future.
Venture capital is an alternative investment that is generally only available to institutional and accredited investors. Pension funds, large financial institutions, high net worth investors (HNWIs) and wealth managers typically invest in venture capital funds.
How does venture capital work?
Venture capitalists finance new businesses in the early stages of their development. In exchange for funding, a venture capitalist takes an equity stake that is typically less than 50%. The goal of a venture capital fund is to increase the value of the startup and then profitably exit the investment by selling its stake or through an initial public offering (IPO).
There are four types of players in the venture capital industry:
- Contractors who are starting businesses and need financing to realize their vision.
- Investors who are willing to take significant risks to seek high returns.
- Investment bankers who need companies to sell or IPO.
- Venture capitalist who profit by creating markets for entrepreneurs, investors and bankers.
Entrepreneurs seeking capital submit business plans to venture capitalists in hopes of securing funds. If the venture capitalist sees the business plan as promising, it will conduct due diligence, which involves a deep dive into the business model, product, management, operating history and other relevant areas to assess the quality of the business and the idea.
Regardless of how far along the company is, a venture capital firm also vets directors thoroughly, from their education and work experience to relevant personal details. Thorough due diligence is essential to making sound investment decisions.
If the due diligence process is successful and the growth prospects of the business are promising, the venture capitalist will offer capital in exchange for equity participation. Often the capital is provided in multiple rounds and the venture capital firm will take an active role in managing the holding company.
Stages of venture capital investment
As portfolio companies grow and evolve, they go through different stages of the venture capital process. Some venture capital funds specialize in particular stages, while others may consider investing at any time.
- Seed funding. This is the first round of venture capital funding, in which venture capitalists offer a small amount of capital to help a new company develop its business plan and create a minimum viable product (MVP ).
- Seed funding. Commonly referred to as Series A, Series B, and Series C rounds, seed capital helps startups through their first stage of growth. Funding amounts are higher than in the seed cycle as startup founders scale up.
- Funding at an advanced stage. The Series D, Series E, and Series F rounds are late-stage venture capital financings. At this point, the startups should be generating revenue and showing robust growth. Although the company is not yet profitable, the outlook is promising.
The goal of the venture capital firm is to grow its portfolio companies to the point where they become attractive targets for acquisitions or IPOs. The venture capital firm aims to sell its holdings at a profit and distribute the profits to its investors.
What are venture capital funds?
Like other types of private equity funds, venture capital funds are structured as limited partnerships. The general partners manage the fund and serve as advisors to the fund’s portfolio companies. Investors in the fund are limited partners.
A venture capital fund makes multiple investments in a stable of promising companies. They tend to take minority stakes of less than 50% in their portfolio companies, in an effort to increase their value. Exit strategies include selling the holding company to another public company or taking the holding company public. The venture capital firm may also sell shares of the holding company on the secondary market.
Venture capital funds generate income by charging management and performance fees. The most common fee structure is two and twenty: the venture capital firm charges its investors a management fee of 2% on total assets under management (AUM), plus a performance fee equal to 20% benefits.
Well-known venture capital funds
Venture capital funds invest in many industries, but most venture capital investments are concentrated in the technology sector. Most of the better-known venture capital firms are based in Silicon Valley, although they can be found all over the United States. Some of the larger venture capital funds include:
- Andreesen Horowitz. Founded in 2009 by Marc Andreesen and Ben Horowitz, Andreesen Horowitz is based in Menlo Park, Calf. This venture capital fund invests in early-stage startups and growing companies in industries such as enterprise computing, gaming, social media, e-commerce, and cryptocurrency.
- Capital Sequoia. One of the top venture capital firms in the world, Sequoia is also based in Menlo Park, Calf. Sequoia Capital has invested in some of the most well-known technology companies in the United States, including WhatsApp, LinkedIn, Paypal and Zoom, among others.
- Combinator. Launched in 2005, this venture capital fund and startup accelerator is considered one of the most successful startup accelerators in Silicon Valley. He has invested in over 3,000 companies, including DoorDash, Coinbase, Instacart, Dropbox, and Reddit, among many others.
Private Equity vs. Venture Capital
As stated above, venture capital is considered a form of private equity. The clearest difference between them is that venture capital backs entrepreneurial ventures and startups, while private equity tends to invest in established companies.
- Invests in startups
- Generally acquires holdings of less than 50% of the capital of a company
- May participate in the management of portfolio companies
- Extremely popular in the tech industry
- Invests in businesses that have not yet generated significant revenue or profit
- Generates a return when a holding company is sold or taken public
- Invests in established companies and often prefers companies in financial difficulty
- Acquisition of majority stake in portfolio companies
- Almost always actively involved in the management and operation of portfolio companies
- Generates a return when the portfolio company is sold or listed
How to invest in venture capital
Venture capital investment has traditionally been limited to accredited investors and institutional investors. Investing in venture capital funds requires a substantial financial commitment and the ability to conduct thorough due diligence.
Retail investors who follow the venture capital industry can benefit from insights that inform their future investment decisions. Venture capitalists frequently focus on new industry segments that can become long-term growth engines. Paying attention to these developing companies and industries can give retail investors ideas for their own strategies.
Rayol Hwang, CEO of Hillstone Partners, recently argued that retail investors should play a bigger role in venture capital investments in the future.
“Through smart contracts and tokenization, venture capital can be made accessible to all retail investors,” Hawang said.
The company is set to launch Hillstone Finance, which will leverage blockchain technology to provide investment opportunities typically off-limits to retail investors.
In the UK, efforts are also being made to enable retail investors to access venture capital. Forward Partners, a UK-based venture capital firm, included retail investors in an IPO made earlier this year.
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