Entrepreneurs can turn to the various available financing options when starting a new company, among them is venture capital. Venture capital is essentially a type of funding given out to startup firms in the early stages of development. These firms are often considered to have both high risk and high growth potential and center on new technology or healthcare, including things such as new medicine, networking, software, and the internet. More recently, there’s an entirely new breed of venture capital firms like AMMA Private Equity that primarily focus on socially responsible companies.
New startup firms often turn to venture capital firms for financing because their business is new, risky, and unproven, where the most traditional sources of financing like bank loans are unavailable. However, unlike in the conventional forms of financing where the businesses are expected to pay the loan amount back plus interest, venture capital usually comes in exchange for ownership of a certain number of shares in the company, meaning they will have a say in the future direction of the company. Moreover, venture capital companies can offer to fund at any stages of a company’s growth, meaning that not all companies will receive venture capital in their early stages of development. Some of the most famous companies that started out with venture capital investments include Microsoft, Apple, Google, and Compaq.
The entity that deals with venture capital is referred to as a venture capitalist and is usually a person who works for the venture capital firm. In general, the firm usually has one or several investment portfolios, which are owned by limited partnerships. For most cases, the venture capitalist will be the general partner in the portfolio, and institutions, individuals, and other investors such as pension funds, foundations, and university endowments are the limited partners in the partnership.
Venture capital is mostly only used for the high-growth potential industries, where risk is also much higher. There’s usually no assets (or are very little) to back the loan in case the company defaults, and therefore the likelihood of acquiring financing from venture capitalist are also lower. Also, the potential for making very high payouts should be significantly high to achieve a successful investment.
The investors can also exit or cash out when the company lists on the stock market or gets acquired. This is often done right before a public listing or an acquisition by selling the shares if they are certain they have met their investment goals, or for the sole purpose of de-risking. Although startups tend to have a high failure rate, making venture capital investment highly risky, most of these firms bank on finding a unicorn (an outlier startup) such as Facebook, which will generate returns huge enough to compensate for losses from other startups.
In this case, venture capitalists have portfolio comprising of multiple startups at any given time. Moreover, they may also operate in different geographical locations and even focus on different industries to diversify risk. Venture capital firms tend to prefer startups that are already validated by the market, showing a high growth potential. Such companies would have already acquired a relatively small but steady and increasing user base, and simply need funds to scale their infrastructure, improve their sales and marketing, or add on the product features.
Venture capital firms may also invest as a syndicate where multiple firms invest in the same startup in the same round. However, one firm will invariably be a lead investor. The lead investor firms usually have done the most due diligence on the startup and may be responsible for arranging the syndicate and developing the terms of the deal.