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What is Venture Capital?

There are numerous big companies listed on the stock exchanges today. However, it is likely that some of these million/billion dollar corporations that we see today were helped by investments from third-parties to get started. For an early-stage business, basic expenses such as rent, equipments needed for their operation, furniture, etc. can be a burden. Despite using personal funds and obtaining bank loans, there could be times when a supporting arm to stabilize their business may become essential. This is where venture capital (similar to angel investing) plays an important role to prop up companies needing high initial capital or seeking fast growth.

What is Venture Capital?

Venture capital (VC) refers to investments made to fund a fledgling business. Generally, VC is used to aid start-up companies but it is also possible for a growing company to use VC. Typically, a VC firm will obtain money from cash-rich individuals, companies, pension funds, etc. to form a fund. Once the VC firm has accumulated a significant amount (say, $10 million), it will identify a few companies whose sector and business plans fit their investment profile. For example, in the 1990s, many software companies were helped by investments from VC firms. Those VC firms were partial to the tech world, while in today’s market, alternative energy firms may be the focus.

Usually, there are several rounds of seed funding and growth funding involved. Upon investment, a VC firm will get a certain number of shares in the venture that they could cash out at a later date. They may also get some say in the new company’s management decisions including the ability to have their representative as a member on the board of directors.

How does a VC Firm Profit

VC is made available to start-up ventures with the hope that their capital will yield a profit in the next few years. If the start-up company offers an IPO within a few years, then the VC firm can cash out by selling its shares. The same sale can also occur if the fledgling venture is sold to an established corporation (think mining companies). After cashing out, a VC firm will hope to have more cash on hand than they invested (started out with).

As may be evident, not all ventures chosen by a VC firm will become successful enough to offer an IPO or be acquired. There are bound to be companies that turn out to be damp squibs. Typically, if a VC firm selects 5 companies to invest their $10 million fund, then they only look for an overall net profit at the end of a certain period. Needless to say, VC firms are in a high potential, high risk line of business.

The Pros and Cons of VC

Pros. Evidently, the access to cash for initial expenses is very beneficial to fledgling businesses. Once personal funds and bank loans have been exhausted and the business still needs capital, VC firms are the saviors. For many start-up businesses, VC firms also offer networking benefits. The VC firm may have contacts in that specific industry or experts on its own payroll that a newcomer could tap.

Cons. One of the possible stumbling blocks is the degree of control given to a VC firm in return for its investment. The ability to have a say in management decisions may lead to discord between the business owners and the VC firm.

Have you been part of a start-up company that used VC? Have you worked for a VC firm? Do you have any stories to share from either side?

About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.  You can read his other articles here.

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About the author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.

{ 2 comments… add one }
  • JAMES May 2, 2012, 10:27 pm

    My brother worked for Thomas Lee, so I got a pretty good look into what goes on in a VC firm. The analysts at those firms are very sharp. It was a rare occurrence where Thomas Lee lost money on a deal

  • John @ Financial Planner Irvine May 13, 2012, 12:59 pm

    The cons of getting on a VC contract can be solved I think by maybe having a written agreement when it comes to who has a say in management decisions. If this is clear, then discord may be prevented.

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