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 and can also be provided through expertise or networking by venture capitalists.

When venture capitalists look to invest in a business, they consider several factors, such as the 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 managing 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 a company’s very start or the seed stage.

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 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 rather than equity instruments.

This provides the venture capitalists a safeguard while also allowing them 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.

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, and 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 by 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.

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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 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.

There is no specific industry that venture capital firms target. Venture capital firms tend to go with the trend and go for industries 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 successful businesses 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 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 in 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 bring investment with not only 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 assets as security to 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 participate in a company’s management and decision-making process. 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 for similar sources of finance.
  • As previously mentioned, venture capitalists look to recover their investment within 3 to 7 years. This may be stressful and considered fast-paced for startups with no prior experience.
  • A company needs to adapt to a formal structure to accommodate venture capitalists. This means having a proper board of directors and formal reporting structures. Moreover, this formal structure may cause delays in a company’s decision-making process, especially when time is of the essence for new companies.

Top 10 Venture Capital Firms You Might Want to Know

Here is the list of the top 10 venture capital firms, along with their details:

1. Sequoia Capital – Headquartered in Menlo Park, California, Sequoia Capital is one of the largest venture capital firms in the world. The firm focuses primarily on early-stage technology investments and has invested in over 250 companies, including Apple, Google, Oracle, and YouTube.

2. Accel Partners – Headquartered in Palo Alto, California, Accel Partners is a venture capital and growth equity investment firm that invests in early- to mid-stage startups across various sectors. Notable investments include Wednesday Group, Dropbox, and Slack.

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3. Kleiner Perkins Caufield & Byers (KPCB) – Founded in 1972 by Tom Perkins and Eugene Kleiner from Stanford Research Institute (SRI), KPCB has invested over $10 billion into more than 800 organizations over its history with major investments such as Amazon and Google.

4. Andreessen Horowitz – Founded by Marc Andreessen and Ben Horowitz in 2009, Andreessen Horowitz is a venture capital firm that invests in software technologies across all stages, from seed to late-stage growth companies such as Airbnb, Instacart, and Coinbase.

5. NEA – Founded in 1977 by New Enterprise Associates (NEA) is one of the oldest venture capital firms operating today with investments across various industry verticals such as energy, healthcare IT, and financial services technology companies like GoDaddy and Snapchat, among others.

6. Union Square Ventures – Founded by Fred Wilson in 2003 as an NYC-based venture capital firm focusing on early-stage investments primarily concentrated in web-based businesses such as Twitter and Etsy, among others.

7. Greylock Partners – Greylock Partners was founded by Bill Elfers in 1965, making it one of the oldest venture capital firms today, looking at both earlier-stage opportunities and later-stage rounds for established startups such as Airbnb and Dropbox, among others.

8. First Round Capital – Founded by Josh Kopelman in 2004 as a seed stage focused fund aiming towards supporting early entrepreneurs through advice network access to employees from former portfolio companies like Uber or Warby Parker, among others.

9. Benchmark– Founded In 1995, Benchmark focuses exclusively on early-stage investments, often leading rounds with other investors like Instagram or LinkedIn, among others, amongst many other portfolio companies who have gone public since then, including eBay or Twitter

10. DST Global – DST Global was founded by Yuri Milner back in 2005, focusing almost exclusively on late-stage investments not only investing but also actively helping with the international expansion of some of the most promising startups like Spotify or Airbnb, amongst many others

Conclusion

Venture capital can help any startup 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 greatly.

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

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