• Venture capital firms specialize in providing equity financing for firms that are in an early stage of development (start-ups).
• Examples of companies that received venture capital funding in their early development include Apple, Federal Express, Microsoft, Genentech, and Google.
• Venture capital (a.k.a. private equity) is a pool of capital most commonly organized as a limited partnership. The venture capital firm serves as the general partner and investors are the limited partners. Limited partners can include pension funds, university endowment funds, wealthy individuals, and other financial institutions and corporations.
• Managers of venture capital firms (venture capitalists) closely follow the technology and market developments in their area of expertise (e.g., computer software, communications, computer hardware, medical/health, industrial/energy, biotechnology, retailing, restaurants, etc.)
• They screen entrepreneurs and their business concepts prior to making an investment. To diversify risk, they create a venture fund that is a portfolio of investments in young companies.
• Venture capitalists are not passive equity investors. They structure a financing deal with great attention to creating the right incentives and compensation for the start-up firm’s owners. They are also instrumental in raising additional financing during future stages of the firm’s lifecycle.
TYPES OF VENTURE CAPITAL FINANCING
Types of venture capital financing provided to companies:
• Seed: prior to a product being developed or to the start-up being organized.
• Early Stage: after a company has expended initial capital in development and market testing and is now ready to begin full-scale operations and sales.
• Expansion Stage: the company is producing and shipping and has growing inventories and accounts receivable.
• Later Stage: company is now breaking-even or profitable and requires funds for plant expansion, full-scale marketing, and working capital.
• MBO/Acquisition: This situation occurs when managers wish to purchase an independent company or a division or product line of their employer, thus creating a new independent firm.
ROLE OF VENTURE CAPITALISTS
Venture capitalists (VCs) continuously monitor their companies.
• VCs typically serve on the company’s Board of Directors.
• VCs provide mentoring and strategic advice to the company’s managers.
• VCs often provide business contacts to company managers.
• VCs help recruit additional managers for the company.
• VCs set company performance targets. If these targets are not met, VCs may have the option of replacing the company founder as the CEO.
• Empirical evidence finds that
• Companies with innovative, rather than imitator, business plans are more likely to receive VC financing.
• Ceteris paribus, companies obtaining VC financing bring their products to market more quickly.
• A venture capital firm typically raises money for a venture capital fund by obtaining commitments from limited partner investors. Based on the fund’s prospectus, limited partners agree to make investments for a period that is often 10 years.
• After commitments are obtain, the VC begins making investments in young companies. VCs make “capital calls” to the limited partners as funds are dispersed to the start-up companies.
• The most common way that the VC obtains a return from its investment in a start-up company is by the company being acquired by a mature corporation. In other cases, the VC obtains a return when the company issues an IPO. After the IPO, the stock held by the VC is given to the partners who can continue to hold it or liquidate it.
• Most commonly VCs are private independent firms. However, sometimes a VC firm is a
• Subsidiary of a commercial bank holding company (BHC). This allows the BHC to provide (high-risk) equity financing that could not be made by BHC’s commercial bank subsidiary.
• Subsidiary of an investment bank. Investment banks see VC investing as a way to groom companies for an IPO.
• Subsidiary of a non-financial corporation (a.k.a. direct investing). The parent company’s capital is used to invest in young companies that may produce synergies or cost savings for the parent.
• The major alternatives to venture capital financing are
• Angels: These are wealthy individuals (often former corporate executives) who mentor a company and provide financing and expertise to start-ups.
• Commercial banks: often in the form of lines of credit.
• Government: Through grants or Small Business Administration financing and loan guarantees.
• Self-financing: including family members and friends.
• VC financing grew tremendously during the 1990s. The recession and decline in technology firms (a major source of VC investment), led VCs to reduce their investments because prospects for making profits in start-ups was greatly reduced.
• While it may be some time before VC activity returns to the level of the “bubble” years of 1999-2000, VC financing will remain an important source of funding for entrepreneurs with innovative business strategies.