From the Small Business Administration
Venture capital is a type of equity financing that addresses the funding needs of entrepreneurial companies that for reasons of size, assets and stage of development, cannot seek capital from more traditional sources like public markets and banks. Venture capital investments are generally made as cash in exchange for shares and an active role in the invested company.
Venture capital differs from traditional financing sources in that venture capital typically:
- Focuses on young, high-growth companies
- Invests equity capital, rather than debt
- Takes higher risks in exchange for potential higher returns
- Has a longer investment horizon than traditional financing
- Actively monitors portfolio companies via board participation, strategic marketing, governance, and capital structure
Successful long-term growth for most businesses is dependent upon the availability of equity capital. Lenders generally require some equity cushion or security (collateral) before they will lend to a small business. A lack of equity limits the debt financing available to businesses. Additionally, debt financing requires the ability to service the debt through current interest payments. These funds are then not available to grow the business.
Venture capital provides businesses a financial cushion. However, equity providers have the last call against the company’s assets. In view of this lower priority and the usual lack of a current pay requirement, equity providers require a higher rate of return/return on investment (ROI) than lenders receive.
UNDERSTANDING VENTURE CAPITAL
Venture capital for new and emerging businesses typically comes from high net worth individuals (“angel investors”) and venture capital firms. These investors usually provide capital unsecured by assets to young, private companies with the potential for rapid growth. This type of investing inherently carries a high degree of risk. But venture capital is long-term or “patient capital” that allows companies the time to mature into profitable organizations.
Venture capital is also an active rather than passive form of financing. These investors seek to add value, in addition to capital, to the companies in which they invest in an effort to help them grow and achieve a greater return on the investment. This requires active involvement; almost all venture capitalists will, at a minimum, want a seat on the board of directors.
Although investors are committed to a company for the long haul, that does not mean indefinitely. The primary objective of equity investors is to achieve a superior rate of return through the eventual and timely disposal of investments. A good investor will be considering potential exit strategies from the time the investment is first presented and investigated.
Business “angels” are high net worth individual investors who seek high returns through private investments in startup companies. Private investors generally are a diverse and dispersed population who made their wealth through a variety of sources. But the typical business angels are often former entrepreneurs or executives who cashed out and retired early from ventures that they started and grew into successful businesses.
These self-made investors share many common characteristics:
- They seek companies with high growth potentials, strong management teams, and solid business plans to aid the angels in assessing the company’s value. (Many seed or startups may not have a fully developed management team, but have identified key positions.)
- They typically invest in ventures involved in industries or technologies with which they are personally familiar.
- They often co-invest with trusted friends and business associates. In these situations, there is usually one influential lead investor (“archangel”) whose judgment is trusted by the rest of the group of angels.
- Because of their business experience, many angels invest more than their money. They also seek active involvement in the business, such as consulting and mentoring the entrepreneur. They often take bigger risks or accept lower rewards when they are attracted to the non-financial characteristics of an entrepreneur’s proposal.
UNDERSTANDING EQUITY CAPITAL
Equity capital or financing is money raised by a business in exchange for a share of ownership in the company. Ownership is represented by owning shares of stock outright or having the right to convert other financial instruments into stock of that private company. Two key sources of equity capital for new and emerging businesses are angel investors and venture capital firms.
THE VENTURE CAPITAL PROCESS
A startup or high growth technology companies looking for venture capital typically can expect the following process:
- Submit Business a Plan. The venture fund reviews an entrepreneur’s business plan, and talks to the business if it meets the fund’s investment criteria. Most funds concentrate on an industry, geographic area, and/or stage of development (e.g., Startup/Seed, Early, Expansion, and Later).
- Due Diligence. If the venture fund is interested in the prospective investment, it performs due diligence on the small business, including looking in great detail at the company’s management team, market, products and services, operating history, corporate governance documents, and financial statements. This step can include developing a term sheet describing the terms and conditions under which the fund would make an investment.
- Investment. If at the completion of due diligence the venture fund remains interested, an investment is made in the company in exchange for some of its equity and/or debt. The terms of an investment are usually based on company performance, which help provide benefits to the small business while minimizing risks for the venture fund.
- Execution with VC Support. Once a venture fund has invested, it becomes actively involved in the company. Venture funds normally do not make their entire investment in a company at once, but in “rounds.” As the company meets previously agreed upon milestones, further rounds of financing are made available, with adjustments in price as the company executes its plan.
- Exit. While venture funds have longer investment horizons than traditional financing sources, they clearly expect to “exit” the company (on average, four to six years after an initial investment), which is generally how they make money. Exits are normally performed via mergers, acquisitions, and IPOs (Initial Public Offerings). In many cases, venture funds will help the company exit through their business networks and experience.
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