It may seem like it has been around since the beginning of time but venture capital is a fairly recent part of business and industry. It started sometime after 1945 with the end of World War II. Venture capital gained popularity in the 1970s and blew up in the 1980s with the silicon valley boom in America and the general growth of technology businesses around the world. Modern venture capital features firms which are specifically dedicated to providing venture capital funding to start up businesses.
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What Is Venture Capital?
Venture Capital or VC firms are companies that invest funds into early start ups in which they see the potential for growth and profitable business. The aim of any start up is to grow or scale. By increasing the scale at which they operate, start ups will boost their client base and therefore absolute profit. Operating at a bigger size also comes with benefits in economies of scale. Whether it is a manufactured good or service business, in most cases operating at a larger scale brings cost and performance benefits. Growth, of course, requires funding. Increased production or service capacity, customer acquisition costs, working capital and cash flow all require funding and this is where venture capital firms come in. The benefit to venture capitalists are many. They gain through capital appreciation of their investment stake in the business. In some cases, they can gain through interest payments or dividend income though the latter is rare in growth start ups. Investing in a start up while it is still in its infancy allows venture capitalists to get bargain deals on equity. Our discussion on what venture capital is has revealed some important venture capital features. Let’s now look at these features in detail to understand the features of venture capital.
The first feature of venture capital we can identify is that it is a high-risk activity. As pointed out earlier venture capital in its modern form invests in start up companies. These are usually companies which have a new idea or technology and are determined to build a business around it. Big businesses of today such as Facebook are examples of venture capital-funded start ups. While Facebook represents a major start up venture capital success story, We Work is a recent example of a venture capital start up failure. The co-working space start up came crashing in late 2019. This shows that venture capital is a very risky business and there are successes and failures in venture capital-funded start ups. It is estimated that as many as 25% to 30% of venture capital-funded firms fail.
Lack Of Liquidity.
Venture capitalists buy into start ups as small companies. What this means is there are very few ways to recoup their investment namely the start up succeeding and going public, dividends which growth companies rarely pay and someone else buying their investment out. This lack of liquidity is another important feature of venture capital. The venture capitalist cannot easily divest if things are looking bad for the start up. They and their money are tied to the start up. We will see how this venture feature capital feature leads to the existence of another venture capital feature which is participation in management.
Long Term Horizon.
Another important venture capital feature is the time horizon involved in venture capital funding. Start ups take a lot of time to scale and grow to a size where they can either publicly float their shares become attractive enough for someone to buy out the initial venture capital investors. Many start ups go through multiple funding rounds before they reach maturity. In each round, more investors are brought into the organisation. In the meanwhile, these investors will hold on to their equity until their defined exit arrives, more on this later. Venture capital features a long time horizon before investors can recoup their investment.
Equity Participation And Capital Gains
Venture capitalists participate in start ups by buying equity in the start up, this means they become part owners. While venture capital features no liquidity for the investment and hence a long term horizon when making venture capital investments, venture capitalists do accrue capital gains in their investments. As the start up grows the valuation grows too, hence the venture capitalist’s investment grows in value. As more investors come on board and as the company grows this is capital gain to the investor. Of course, this can only be realised when they sell their investment. In the meantime, the venture capitalist maintains voting rights according to the proportion of their investment. As the venture capital industry develops hybrid equity such as debentures have become a feature of venture capital funding. Debentures are equity shares which have a mandated payment similar to interest on the invested amount. While debentures are equity instruments in their legal form they have the substance of debt finance. Debentures can be redeemable, where the start up is required to buy back the shares on a specified date. This completely mirrors debt.
Venture capital features a bias toward innovative projects. Venture capitalists tend to back start ups that have new and innovative ideas. The allure of dominating new exciting markets is one of the major reasons behind this focus on new and innovative ideas. This is why the aforementioned venture capital-funded start ups Facebook and We Work attracted funding. Facebook represented a new approach to using the internet for communication via the concept of social media. The concept of social media was not completely new but Facebook’s approach to it was and it paid off. WeWork’s outlook on co-working spaces was also innovative although the company ultimately failed.
As a condition of investment venture capital features venture capitalists participating in company management or reserving the right to participate in management appointments. Venture capitalists do take on a considerable risk of failure and one of the trade-offs is a desire to make the sure the start up is managed in the best possible way. They may participate directly or have a choice of who should be appointed to critical positions such as chief financial officer or operations manager. This venture capital feature doesn’t guarantee success but certainly eases the conscience of venture capitalists while giving the start up the best chance of success.
The final venture capital feature we will identify is a defined exit. Venture capitalists tend to be clear from the day they invest in a start up how they will exit the company. This may be through disposing of the investment on the open market when the company goes public, share buy-back arrangement or other means. It is commonly held that venture capitalists while long term in outlook are interested in the capital gain their investment makes in the growth phase of a start up. While it is possible venture capitalists are not particularly interested in remaining invested in a company indefinitely.
There are many venture capital features that make it unique from general equity investment in businesses. Each feature shows how the terms in venture capital agreements have evolved into the type of venture capital arrangements we have in the modern business world.