Venture capital is financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks and any other financial institutions. However, it does not always take just a monetary form; it can be provided in the form of technical or managerial expertise.
Though it can be risky for the investors who put up the funds, the potential for above-average returns is an attractive payoff. For new companies or ventures that have a limited operating history (under two years), venture capital funding is increasingly becoming a popular − even essential − source for raising capital, especially if they lack access to capital markets, bank loans or other debt instruments. The main downside is that the investors usually get equity in the company, and thus a say in company decisions.
BREAKING DOWN 'Venture Capital' A bank guarantee is a lending institution⋅s promise to cover a loss if a borrower defaults on a loan. The guarantee lets a company buy what it otherwise could not, helping business growth and promoting entrepreneurial activity. For example, Company A is a new restaurant wanting to buy $3 million in kitchen equipment. The equipment vendor requires Company A to provide a bank guarantee to cover payments before shipping the equipment. Company A requests a guarantee from the lending institution keeping its cash accounts. The bank essentially cosigns the purchase contract with the vendor.
Angel Investors For small businesses, or for up-and-coming businesses in emerging industries, venture capital is generally provided by high net worth individuals (HNWIs) − also often 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 enterprises.
Angel investors are typically a diverse group of individuals who have amassed their wealth through a variety of sources. However, they tend to be entrepreneurs themselves, or executives recently retired from the business empires they've built. 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 business sectors with which they are familiar. If they haven't actually worked in that field, they might have had academic training in it. 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 company's business model, products, management and operating history, among other things.
Since venture capital tends to invest larger dollar amounts in fewer companies, this background research is very important. Many venture capital professionals have had prior investment experience, often as equity research analysts; others have Masters in Business Administration (MBA) degrees. Venture capital professionals also tend to concentrate in a particular industry. A venture capitalist that specializes in healthcare, for example, may have had prior experience as a healthcare industry analyst.
Once due diligence has been completed, the firm or the investor will pledge an investment of capital in exchange for equity in the company. These funds may be provided all at once, but more typically the capital is provided in rounds. The firm or investor then takes an active role in the funded company, advising and monitoring its progress before releasing additional funds.
The investor exits the company after a period of time, typically four to six years after the initial investment, by initiating a merger, acquisition or initial public offering (IPO).
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