Venture capital

Venture capital is capital provided by outside sources for financing of new, growing or struggling businesses. A venture capitalist (VC) is a person who makes such investments. A venture capital fund is a pooled investment vehicle (often a partnership) that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. A limited partner is a person or organization who invests capital in a venture capital fund for financial gain. A general partner is a venture capitalist who manages the fund and makes investments. Venture capital investments generally are high risk investments but offer the potential for above average returns. Investments by a venture capital fund can take the form of either equity participation or a combination of equity participation (typically with preferred stock) and debt obligation—often with convertible debt instruments that become equity if a certain level of risk is exceeded. In most cases, the venture capitalist becomes part owner or a member of the Board of Directors of the new venture. Most investments are structured as preferred shares—the common stock often reserved by covenant for a future buyout, as VC investment criteria usually include a planned exit event (an IPO or acquisition), normally within three to seven years. In case a venture fails, then the entire funding by the venture capitalist has to be written off.

Venture capital fund operations

Venture capitalists are very selective in deciding what to invest in. A common figure is that they invest only in about one in four hundred ventures presented to them.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

They are only interested in ventures with high growth potential. Only ventures with high growth potential are capable of providing the return that venture capitalists expect, and structure their businesses to expect. Because many businesses cannot create the growth required to have an exit event within the required timeframe, venture capital is not suitable for everyone.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

Venture capitalists usually expect to be able to assign personnel to key management positions and also to obtain one or more seats on the company's board of directors.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

Venture capitalists hope to be able to sell their stock, warrants, options, convertibles, or other forms of equity in three to ten years: this is referred to as harvesting. Venture capitalists know that not all their investments will pay off. The failure rate of investments can be high; anywhere from 20% to 90% of the enterprises funded fail to return the invested capital.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

Many venture capitalists try to mitigate this problem through diversification. They invest in companies in different industries and different countries so that the risk across their portfolio is minimized. Others concentrate their investments in the industry that they are familiar with. In either case, they usually work on the assumption that for every ten investments they make, two will be failures, two will be successful, and six will be marginally successful. They expect that the two successes will pay for the time given to, and risk exposure of the other eight. In good times, the funds that do succeed may offer returns of 300 to 1000% to investors.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

Venture capital partners (also known as "venture capitalists" or "VCs") may be former chief executives at firms similar to those which the partnership funds. Investors in venture capital funds are typically large institutions with large amounts of available capital, such as state and private pension funds, university endowments, insurance companies and pooled investment vehicles.

Related Topics:
Chief executives - Pension fund - Endowment - Insurance - Pooled investment

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

Most venture capital funds have a fixed life of ten years—this model was pioneered by some of the most successful funds in Silicon Valley through the 1980s to invest in technological trends broadly but only during their period of ascendance, to cut exposure to management and marketing risks of any individual firm or its product.

Related Topics:
Silicon Valley - 1980s

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

In such a fund, the investors have a fixed commitment to the fund that is "called down" by the VCs over time as the fund makes its investments. In a typical venture capital fund, the VCs receive an annual "management fee" equal to 2% of the committed capital to the fund and 20% of the net profits of the fund. Because a fund may run out of capital prior to the end of its life, larger VCs usually have several overlapping funds at the same time—this lets the larger firm keep specialists in all stage of the development of firms almost constantly engaged. Smaller firms tend to thrive or fail with their initial industry contacts—by the time the fund cashes out, an entirely new generation of technologies and people is ascending, whom they do not know well, and so it is prudent to re-assess and shift industries or personnel rather than attempt to simply invest more in the industry or people it already knows.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~