Venture capital (VC) is financial capital provided by investors to small businesses that have high long-term potential. It is a type of private equity.
Private equity refers to the stocks (shares) and debts of private companies, i.e. firms not listed on a stock exchange.
It is a primary source of funding for startups that do not have access to capital markets or are not able to secure a bank loan or complete a debt offering. They need capital for growth, new products or to enter new markets.
Most venture capital comes from a group of wealthy investors, investment banks, or other financial institutions.
It does not solely focus on financial funding, but may also help provide managerial and technical expertise.
Sue, a venture capitalist, likes Sam’s super idea and backs him – she owns 60% of the company they set up. After his product has sold really well, she decides to sell the business. Sam walks off with a tidy $10m (40% of $25m).
Venture capital makes up a very small part of the private equity world. About $25 billion annually goes into venture funds, which is a drop in the ocean compared to private equity funds which go into buyouts, recapitalizations, rollups, etc.
Venture capitalists provide funding in the interest of generating a return through an an IPO or trade sale of the company.
It is different from raising debt or a loan from a lender as lenders have a legal right to repayment of the capital (regardless of how well the business performs). Venture capitalists don’t have a legal right to any repayment as they are essentially purchasing an equity stake in the business and their return depends on how profitable the business becomes.
There are six main stages of venture funding:
- Seed funding: financing needed to prove a new idea. This occurs at the very early stage of a business, the idea or conceptual stage.
- Start-up: capital for costs associated with marketing and product development.
- Growth (Series A round): funds for sales and manufacturing.
- Second-Round: capital for companies that are selling product without turning a profit.
- Expansion: expansion money for a relatively new company that has become profitable.
- Exit of venture capitalist: finance provided to help the company go public.
Difference between an angel investor and venture capitalist: venture capital is money invested by firms – they often use other people’s money. An angel investor is an individual, not a company, who uses his or her own money to invest in startups.
Internet giants have become venture capitalists
Google Inc., for example, has a large venture capital division called Google Ventures.
In July, a Google Ventures European fund was launched with an initial investment of $100 million. According to Google, Europe is teeming with good ideas and it wants to get in there to back interesting startups.
In fact, several companies Google has acquired during the last couple of years were startups it funded. Examples include Nest Labs (bought for $3.2 billion) and Dropcam (which Nest Labs later acquired for $555 million).
Scientists and people with good ideas prefer the venture capital route instead of being employed by a large company. If their idea takes off, they make much more money when a large company comes in and places a bid to take over their business.
What do venture capitalists look out for?
Venture capitalist companies typically see thousands of plans each year and only choose to back one or two dozen.
What they look out for is great people, expertise, ventures that are bringing an ‘unfair advantage’ that are likely to outperform because they have unique insights or market penetration, or perhaps unique defensible technology.
The venture capitalists wrap that all up and marry it with an enormous market opportunity that can create outsize returns for investors – and that’s a venture capital deal.
California – the world’s Mecca of venture capitalists
According to entrepreneur.com, the top ten venture capitalists as of February 2015 were (all but one in California):
1. Andreessen Horowitz, Menlo Park, Calif.
2. Khosla Ventures, Menlo Park, Calif.
3. SV Angel, Palo Alto, Calif.
4. Accel Partners, Palo Alto, Calif.
5. New Enterprise Associates, Menlo Park, Calif.
6. Sequoia Capital, Menlo Park, Calif.
7. Venrock, Palo Alto, Calif.
8. First Round Capital, San Francisco.
9. Spark Capital, Boston.
10. Triangle Peak Partners, Carmel, Calif.
The word ‘capital’, when used on its own, refers to money used to start up a business or expand one, plus vehicles, buildings, machinery and equipment, etc.
If the business is a partnership, venture capitalists often become limited partners, i.e. their liability is limited to the money invested in the business.