What is Venture Capital (VC), and How Does It Work?
Venture capital (VC), a form of private equity, is financing that investors offer to small businesses and startups that have the potential for long-term growth. Venture capital is generally provided by well-off investors, banks and other financial institutions. Venture capital does not have to be in the form of monetary investment. It can also come in the form of technical or managerial knowledge. Venture capital is usually allocated to small businesses with extraordinary growth potential or companies that have grown rapidly and seem poised for continued expansion.
Although it is risky for investors who invest in venture capital, there are attractive returns and the possibility of above-average returns. Venture capital is becoming increasingly popular for new ventures and ventures with a short operating history (under 2 years), especially if they don’t have access to capital markets, bank loans, or any other debt instruments. The downside to venture capital is that investors often get equity in the company and have a say in company decisions.
Understanding Venture Capital
Venture capital deals involve large ownership pieces of a company being created and then sold to a few investors via independent limited partnerships. These partnerships are set up by venture capital firms. These partnerships may include a group of similar businesses.
Venture capital is more focused on new companies looking for substantial capital, while private equity funds tend to be larger and more established companies that seek equity infusions or the chance to have founders transfer some of their ownership.
Histories of Venture Capital
Venture capital is one subset of private equity. Although PE has its roots back in the 19th Century, venture capital developed only after the Second World War.
Georges Doriot, a Harvard Business School professor, is widely considered to be the “Father” of Venture Capital. In 1946, he founded the American Research and Development Corporation (ARD), which raised $3.5 million to invest in companies that had commercialized technology developed during WWII. The first investment of ARDC was made in a company with ambitions to use x-ray technology for cancer treatment. Doriot’s initial investment of $200,000 was repaid with $1.8 million when the company went public, in 1955.
The 2008 Financial Crisis: What Happened?
The 2008 financial crisis caused a major hit to the venture capital sector. Institutional investors who had been a significant source of funding tightened their belts. A diverse group of players has joined the industry due to the emergence of unicorns (or startups valued at over a billion dollars). Notable private equity firms and sovereign funds have joined the ranks of investors looking for multiple returns at low-interest rates and have participated in large-ticket deals. Their participation has led to changes in the venture capital ecosystem.
It was initially funded mainly by Northeast banks, but venture capital shifted to the West Coast as a result of the rise in the tech industry. Fairchild Semiconductor was founded by eight engineers (“the “traitorous 8”) from William Shockley’s Semiconductor Laboratory. It is widely considered to be the first company to receive VC funding. Sherman Fairchild, an east coast industrialist from Fairchild Camera & Instrument Corp, funded it.
Arthur Rock, an investment banker with Hayden, Stone & Co., New York City, was instrumental in facilitating the deal. He later founded one of Silicon Valley’s first VC firms. Davis & Rock helped fund some of the most important technology companies such as Apple and Intel. In 1992, 48% of all investment dollars had gone to West Coast businesses; the Northeast Coast accounted for only 20%.
The situation is not changing much according to Pitchbook (NVCA) and National Venture Capital Association. The fourth quarter of 2021 saw West Coast companies account for more than one-third (but more than 60%) of all deals, while the Mid-Atlantic region accounted only for about one-fifth (and around 20%) of all deals.
However, the Midwest saw a lot of action in the fourth quarter of 2021. The value of deals increased 265% in Denver, and 3311% in Chicago. Despite the decline in West Coast deals, San Francisco Bay Area is still the most important VC market with 630 deals valued at $25 billion.
American VC-backed businesses raised almost $330 billion in 2021, nearly twice the amount that was previously set by $166.6 billion in 2020.
Regulations for your assistance
Venture capital was further popularized by a series of regulatory innovations.
- First, a modification to the Small Business Investment Act (SBIC), in 1958. The tax breaks it provided to investors aided the growth of venture capital. The Revenue Act was amended in 1978 to lower the capital gains tax, which was previously 49% to 28%.
- In 1979, a modification to the Employee Retirement Income Security (ERISA), allowed pension funds to invest as much as 10% in new or small businesses. This change led to an explosion of investments by wealthy pension funds.
- In 1981, the capital gains tax was reduced further to 20%.
These three developments accelerated venture capital growth and the 1980s became a boom time for venture capital. Venture capital funding reached $4.9 billion in 1987. Venture capitalists sought quick returns from high-valued Internet companies during the dot-com boom, which also put the industry in sharp focus. Some estimates suggest that funding levels reached as high as $30 Billion during this period. However, the promises of returns didn’t materialize. Many publicly listed Internet companies with high valuations went bust and ended up in bankruptcy.
Venture capital is usually provided by high net-worth individuals (HNWIs), also known as angel investors, and venture capital firms, for small businesses or up-and-coming companies in emerging industries. The National Venture Capital Association (NVCA), a group of hundreds of venture capital companies that offers to fund innovative businesses, is an organization.
Angel investors typically consist of a wide range of people who have accumulated their wealth from various sources. They are often entrepreneurs or have recently retired from large business empires.
Many key characteristics are shared by self-made investors who provide venture capital. Most investors are looking to invest in well-managed businesses that have a solid business plan and are ready for significant growth. They may also offer to fund ventures in similar or related industries and business sectors. They might have received academic training in the field if they haven’t worked in it. Co-investing is another common practice among angel investors. This involves one angel investor funding a venture with a trusted friend, associate, or another angel investor.
Venture Capital Process
Any business seeking venture capital should first submit a business plan to either a venture capital company or an angel investor. The investor or the firm must conduct due diligence to determine if the proposal is worth investment. This includes thorough research of the company’s operations, business model, and products.
Venture capital is known for investing in smaller companies and tends to make larger investments. This background research is crucial. Venture capital professionals often have prior investment experience as equity research analysts. Others have a Master in Business Administration degree. Venture capitalists tend to focus on one industry. For example, a venture capitalist who specializes in healthcare may have previously worked as an analyst in the healthcare industry.
After due diligence is completed, the firm/investor will make a pledge of capital to the company in return for equity. The funds can be given in one lump sum, or more often, they are provided in smaller amounts. The investor or firm then becomes active in the company and advises and monitors its progress, before releasing additional funds.
After a certain period, usually four to six years, the investor leaves the company by initiating a merger or acquisition (IPO).
Day in the VC Life
As with most professionals in finance, venture capitalists start their day with a copy of the Wall Street Journal and the Financial Times. This information is often consumed daily along with breakfast.
The majority of the day for venture capital professionals is spent in meetings. The meetings include a variety of participants including partners and/or members from his or her venture capital company, executives from an existing portfolio firm, contacts in the field of specialty, and budding entrepreneurs looking for venture capital.
An example of this is a discussion among the entire firm about potential portfolio investments at an early morning meeting. The company’s due diligence team will discuss the pros and cons of making an investment in it. A vote on whether to add the company or not may be held the next day.
A portfolio company may arrange for an afternoon meeting. These meetings are held regularly to assess the company’s performance and determine if the venture capital firm has been wisely investing. The venture capitalist will take evaluative notes and circulate the results amongst the other members of the company.
After spending the afternoon reviewing market news and writing that report, it may be time for a dinner meeting with budding entrepreneurs looking to raise capital. Venture capital professionals get a feel for the potential of the emerging company and decide if further meetings are necessary.
When the venture capitalist leaves the dinner meeting, they might take with them the due diligence report. This will allow them to go over all of the important facts and figures in a final review before heading home.
Trends in Venture Capital
Venture capital funding was originally intended to help start an industry. Georges Doriot was committed to actively contributing to the success of the startup. He offered advice, funding, and connections for entrepreneurs.
In 1958, the SBIC Act was amended to allow novice investors to invest in small businesses and startups. With the increase in funding, came an increase in small business failures. Over the years, VC industry participants have come to rely on Doriot’s original philosophy: providing advice and support for entrepreneurs who are building businesses.
Silicon Valley’s growth
Because the industry is close to Silicon Valley, most deals funded by venture capitalists are in technology industries, such as healthcare, the internet, and mobile telecommunications. Venture capital funding has also been beneficial to other industries. Staples, Starbucks, and others are two notable examples of venture capital.
Venture capital is no longer reserved for elite companies. Venture capital is now open to both established businesses and institutional investors. Google and Intel, for example, have their own venture funds that invest in emerging technology. Starbucks announced in 2019 a $100 million venture fund that will invest in food startups.
Venture capital has grown over the years due to an increase in deal sizes and the inclusion of more institutional investors. Venture capital now has a variety of investors and players who invest at different stages of a startup’s development, depending on their risk appetite.
The Latest Trends
According to data from PitchBook and the NVCA, venture-backed companies attracted a record $330billion in 2021 compared with the record $166billion in 2020. This was an already record. The main drivers of the strong performance are large and late-stage investments. Mega-deals exceeding $100 million have already reached a new high.
A notable trend is an increase in deals with non-traditional VC investors such as corporate investors, hedge funds, and mutual funds. The share of angel investors is also on the rise, reaching record highs.
Because institutional investors prefer to invest in less risky ventures than early-stage companies, which can have high failure rates, late-stage financing is more popular.
However, the increase in funding doesn’t translate into a larger ecosystem. This is true for the deal count and the number of deals financed with VC money. The NVCA predicts that there will be 8,406 deals by 2022, compared to 12,362 for 2020.
Venture Capital: Why is it Important?
Entrepreneurship and innovation are key ingredients of a capitalist economy. However, new businesses are often risky and costly ventures. External capital is often needed to spread the risk of failure. Investors in new companies can get voting rights and equity for cents per dollar for taking on the risk of failure. Venture capital allows founders and startups to succeed.
Venture Capital Investments: How risky?
Many new companies fail, which can lead to early investors losing all their investments. The rule of thumb is that three to four startups out of ten will fail. Three or four more startups will either lose money or return their original investment. A few others may produce significant returns.
Venture Capitalists What Percentage of a company do they take?
VCs typically own 25 to 50% of a company’s new ownership, depending on its stage, prospects, investment amount, and the relationship between investors and founders.
What is the difference between venture capital and private equity?
Venture capital is one subset of private equity. Private equity includes VC as well as leveraged buyouts and mezzanine financing.
What is the difference between an angel investor and a VC?
Venture capitalists, while both can provide funding for startup companies, are usually professional investors who invest in multiple companies. They provide guidance and support to the company by using their professional networks. Angel investors on the other side are wealthy individuals who invest in new companies as a hobby or side project. They may not offer the same expert guidance. Angel investors are more likely to invest first and then be followed by VCs.