What It Is:
How It Works/Example:
There are three general types of venture capital: seed capital, for ideas that have not yet come to market; early-stage capital, for companies in their first or second stages of existence; and expansion-stage financing, for companies that need to grow beyond a certain point to become truly successful. Venture capital can also help a company merge with or acquire other companies.
Although some venture capital comes from private individuals, most venture capital comes from venture capital firms. These firms are often partnerships that obtain their investment funds from wealthy individuals, investment banks, endowments, pension funds, insurance companies, various financial institutions, and even corporations wishing to foster new products and technologies.
A venture capital firm must raise the money it needs to make investments in new businesses. This fund-raising is typically done by circulating a prospectus to potential investors who then agree to commit money to the fund. Once the venture firm has enough commitments, the firm may begin collecting or "calling" those commitments when it wants to make an investment. If and when the venture capital firm invests all of the fund's money, or if it simply wants to expand its investing activities, it may start another fund. Most funds have a fixed life, meaning they must make their investments within a certain period (usually about ten years). Venture capital firms may have several funds going at the same time.
The managers of many venture capital funds receive an annual management fee (usually 2% of the invested capital) and a portion of the fund's net profits (typically 20%). These fees compensate the managers for their expertise and the responsibility to help their investments become successful.
Typically, venture capitalists decide which companies to invest in by reviewing hundreds of business plans, meeting entrepreneurs and company managers, and performing extensive due diligence on investment candidates. They are very selective because they are seeking opportunities in which their investments will grow rapidly and provide a successful exit within a certain timeframe. When they do make a decision to invest, venture capital firms typically purchase a company's preferred stock and/or lend money to the company.
One of the most common and controversial characteristics of venture capital funding is that venture capital firms usually take active management roles and board seats in the companies they invest in. This often means that entrepreneurs give some control over their businesses to venture capital firms, who usually own a portion of the company (in some cases, controlling interest). However, venture capital firms can also provide crucial managerial or technical expertise, particularly in areas where the entrepreneur is less confident. This is especially the case when the venture capitalist specializes in the entrepreneur's industry or niche.
An important part of a venture capital investment is the exit, or the venture capital firm's plans for selling its investment in a company. Usually the exit, also known as the harvest, takes place anywhere from three to ten years, often via an initial public offering or through the merger or sale of the company.
Why It Matters:
Venture capital is an important and necessary form of investment because it fosters entrepreneurship, especially in high-tech and other innovative industries. This in turn promotes job creation and economic growth. At the investment level, venture capital can be tremendously lucrative because it allows investors to get in at the ground level of what could be some of tomorrow's leading companies.
However, venture capital is not without risk. In fact, it is one of the riskiest investments available because many new companies fail or underperform. Venture capital firms anticipate this by diversifying their investments and hoping that their successful investments more than compensate for their losses. Nonetheless, venture capitalists must be willing to take significant long-term risks for what can be high returns.