5 min read
Why venture capital?
Venture capital is often utilized by companies with good ideas, but few assets. Banks are reluctant to issue loans when the company lacks collateral. Even if the bank was sold on the company’s business plan, it would want to charge a higher interest rate to reflect the higher risk it was taking. However, usury laws limit the interest rate a bank can charge, so there is a point at which issuing a loan is impossible.
Venture capitalists are able to fund any company they want. Where a bank makes its profits from the interest on a loan, venture capitalists’ success is tied to the growth of the company. From the company’s perspective, giving up a portion of that growth is worth it in order to receive the funding it needs to make it happen.
Types of venture capital
The most common types of venture capital are equity and convertible debt. Equity is stock in a company that does not need to be paid back. The owner receives an agreed ownership proportion of the company for their investment, and will look to sell their stock when it has gained a certain amount of value.
Convertible debt does need to be paid back at an agreed point in time. It is usually used as a bridge financing tool, where a formal equity valuation isn’t required, and the investor and company both consider the money a loan. Convertible debt can also be treated like equity, if the investor is prepared to convert their investment into equity at some point in time.
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Pros and cons of venture capital
For the company receiving venture capital investment, the main advantage is the funding itself. Remember, these companies are often unable to get bank loans themselves. The main disadvantage is that owners relinquish some control of the company, as investors take an ownership stake.
From an investors point of view, the advantage is the huge potential for returns. In the industry, a ‘home run’ returns 10 times the initial investment. However, the main disadvantage is the high risk involved. The likelihood of a home run is around one in 10, while investors commonly fail to get any return whatsoever.
Venture capital firms
Venture capital firms act as the go-between for people with money to spend, and businesses in need of funding. Firms pool together investments from a range of sources, including wealthy individuals, pension funds, and insurance companies, and use the funds as venture capital. The firm itself controls the investment, including deciding which business to invest in, and receives a cut of the profits for its fee. This cut is typically around 20 percent of the profits of the capital invested, while the rest goes to the investors.
Venture capital investments usually last for the medium term, averaging between five to eight years. Venture capital firms generally aim for between 25-35 percent returns on their investments, though it is not uncommon for investors to not recover their initial investment.
Venture capital firms vary in size. Those with pools of capital totalling a few million dollars are considered small, while large venture capital firms can have billions of dollars in assets, invested in dozens of different companies. They are not necessary in order for a venture capital deal to go ahead, but are popular as market experts, especially among investors that prefer to have a hands-off role.
Venture capitalists investment
So how do venture capitalists figure out which companies they should invest in? A common misconception is they look for businesses with a good new idea. While this does happen, it is considered an even riskier approach than normal.
More prudent is investing in a company in an industry with high growth potential. This approach places more faith in the industry itself, rather than an individual company. For example, in 1980, more than 20% of global venture capital funding went into the energy industry. As markets and industries go up and down, so too does the venture capital investment in those industries, as investors seek the highest returns for their money. Conversely, business people in low growth industries often find it difficult to get venture capital investment, regardless of their abilities or ideas.