An Overview >
Venture Capital Definition
Venture Capital may be defined as funding provided to a new or existing enterprise to purchase an equity ownership therein, in expectation of an above-average return on the investment.
Overview
Venture capital has increasingly become a factor in the financing of new firms. We examine how the value of mature firms determines the incentives of entrepreneurs to start up new firms and of venture capitalists to finance and advise them. Entrepreneurship and the resulting new firms are important for the wider economy because of the innovation processes going on in these firms and the jobs and value which they create over time.
New Enterprises
Venture capital has played an increasing role in the financing of new enterprises over the last couple of decades. Venture Capital firms are generally also entrepreneurial entities that are independent, professionally manage pools of equity capital to invest in high growth companies. VC firms are typically created with funds raised from banks, pension funds, businesses and private individuals. Their equity is typically invested over a limited time span of five to ten years on average. At which time the VC firms expects to exit the companies they fund and take their substantial profits.
Venture Capital Advantages
Most importantly, VCs are active investors as opposed to traditional loan financing by banks. VCs concentrate on and have an advantage in financing small high growth companies. A potential start-up firm is characterized by the high potential of an innovation, but it may also be high risk. Although the entrepreneur has the key role of providing the basic business idea, they typically have few assets and limited commercial experience or know-how. Conversely, the VC may not have the depth of technical expertise in the central idea, but instead has the capital and networks to managers, customers, suppliers, finance professionals and industry product knowledge the entrepreneur lacks. This outside professional expertise enables the VC to support and advise the entrepreneur during the critical first phases of the new company.
Venture Capital Cycle
Venture Capital operates in a cycle. A VC first raises the equity funds, considers possible projects presented by entrepreneurs, and selects one or more for investment. In selecting the start-ups, the VC assesses market potential and the managerial qualifications of the entrepreneur and staff. Upon acceptance, a contract known as a ‘term sheet’ is agreed by both parties. This typically covers the amount of investment, the personnel, performance target dates and associated metrics. The agreement may stipulate that the capital is made available only in several stages, with further capital injection being conditional on meeting certain pre-defined performance targets. The contract will also specify who can make what decisions, and under what circumstances. That is the down-side of private financing, in that the entrepreneurs and management team can be under a VC magnifying glass with ‘helicopter’ VC managers asserting their dominant position, and micromanaging the entity. After all, they reason, it’s their money!! Finally, the contract will state when the investors are to be repaid.
Venture Capital Risk and Reward
Due to the high risks involved, the fate of new companies differs substantially. The most successful ones can be sold at an IPO. The less successful enterprises may only command a private sale, wheree part of the prior VC investment must be written off completely. This exit decision — when and how to get out of the new firm — is the final consideration for the VC.Research suggests that investment by Venture Capital generally causes a significant increase in the probability of first market introduction, patentable inventions and more radical innovations than non-VC-backed firms. Venture Capital accounts for a significant portion of economy wide innovation, and VC backed firms are three times more effective in research and development as in-house corporate firms.