What is Venture Capital?: Definition, How Does It Work? Advantages and Disadvantages

Definition:

Venture capital is finance provided by venture capitalists to a company they deem to have high growth potential or a high future earning prospect. Venture capitalists are veteran investors and maybe anyone from wealthy investors to investment banks or companies.

They generally provide startup and late-stage growth finance to smaller companies. The capital is not always monetary in nature, it can also be provided in the form of expertise or networking by the venture capitalists.

When venture capitalists look to invest in a business, they consider several factors such as the future prospects of the company, the credibility of the management, the amount of information available in the market, how much control they will have in the company, and what their exit strategy is going to be.

Venture capitalists providing venture capital almost always like to be involved in the management of the company and its decision-making processes.

While venture capitalists often capitalize by investing in startups, there are venture capitalists that invest in companies that are above the startup stage. Some venture capitalists may invest in the very start or the seed stage of a company.

Some prefer to invest in companies that are in a stage after their seed stage. Some venture capitalists prefer to invest in a company in its growth stage and follow trends. Each stage is different and has its own risks and rewards for the venture capitalists.

Some venture capitalists like to manage the risks associated with investing in startups by opting for convertible debt instruments rather than equity instruments.

This provides the venture capitalists a safeguard while also giving them the option to convert said convertible debt instruments into equity instruments if they want to. Convertible debt instruments must be repaid by the company when the maturity date is reached if they are not converted.

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Startups looking to raise venture capital must not only rely on their ideas, or their management and network.

It is important that the startup understands and considers many factors such as the stage it is currently at, the type of industry it is operating in, the amount of venture capital it is trying to raise, whether it will offer convertible or ordinary equity instruments.

A startup will need to provide a business plan detailing the objective, mission, activities, team, and funding required to the venture capitalists.

How Does Venture Capital Firms Work?

A venture capital firm is made up of several investors who invest in the venture capital firm. This investment is later used to invest in other businesses. Venture capital firms look for companies with high growth potential.

Venture capital firms generally run for a specific time during which the partners and management of the firm look to invest capital into companies with high reward potentials and recover the initial investment in the shortest amount of time.

Venture capital firms cannot always recover the investment made in companies. Out of every 10 investments made, only one may provide the expected rewards to the venture capital firm.

The return on that one case is enough for the venture capital firm to not only make a profit on that investment but also help cover losses made by the ones where the recovery has not been possible or not as expected.

Venture capital firms have a large sum of capital to invest, however, to diversify the risk, they look into different types of companies in different industries to invest in.

Typically, venture capital firms do not invest all the allocated budget of investment into a company at once. Companies are provided with smaller cheques from time to time. These cheques may range from anything from $200,000 up to even $100 million for bigger companies.

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There is no specific industry that venture capital firms target. Venture capital firms tend to go with the trend and go for industries that are expected to have a high return.

It is also a common practice for venture capital firms to follow angel investors, especially in the technology industry. Some industries yield a very high return for venture capital firms such as the technology industries while some may still be considered a successful business but not yield high returns.

Generally, venture capital firms will invest in a company and expect the funds to be recovered within the first 3 to 7 years. This means they expect the company to either go public or be acquired by another company after that time.

Either way, the fund the venture capital firm initially invested in a company is recovered. Any surplus above the initial investment is the profit the venture capital firm has recovered.

Advantages and Disadvantages of Venture Capital

There are many advantages of a venture capital firm’s investment for a business, however, that is not to say that there are no drawbacks.

Advantages

  • The biggest advantage of venture capital is for startups. Startups are fairly new to the market with no credibility. Therefore, it is hard for them to raise any capital by themselves. A finance injection by venture capitalists can help startups a lot.
  • Many venture capital firms not only bring investment with them but also expertise and networking. It helps new businesses go through the early stages of their lifecycle with greater ease.
  • Unlike other sources of finance such as debt finance, a company is not bound to pay regular interest to venture capitalists. Neither do companies have to provide any assets as security to the venture capital firms.
  • Capital injection by venture capital firms can also help bring publicity to businesses. This is particularly helpful for startups who are new in the market.
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Disadvantages

  • The biggest disadvantage of a venture capital firm investing in a company is the dilution of interest. As previously mentioned, venture capitalists usually take part in the management and decision-making process of a company. This means the original owners of the business may have to take a side role while the venture capitalists manage the company according to their liking. It is also possible for the original owners to lose their ownership of the company.
  • Obtaining venture capital investment for startups can be costly. Not only does it take time to raise finances but it is also harder to grab the attention of a venture capital firm specializing in the modern time when every new startup will be looking towards similar sources of finance.
  • As previously mentioned, venture capitalists look to recover their investment within 3 to 7 years. This may be stressful and may be considered fast-paced for startups with no prior experience.
  • A company needs to adapt to a formal structure to accommodate the venture capitalists. This means having a proper board of directors and formal reporting structures. Moreover, this formal structure may cause delays in the decision-making process of a company especially when time is of the essence for new companies.

Conclusion

Venture capital can help any startup in times when it is hard to raise finance for a company.

Not only do venture capitalists bring monetary investments but also expertise and networking which can help startups a lot.

The advantages of a venture capital firm investing in a business are obvious, in that it provides companies with resources they lack.

However, it may come with certain disadvantages such as dilution of ownership and costs.

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