What Is Venture Capital?
Venture capital, or VC, is a private fund brought together from one or more sources of capital to supply funds in entrepreneurial companies throughout their early stages of development in exchange for an equity share in that company.
Through private equity investment, venture capital typically fuels small startup businesses to fruition into public companies that are attractive and marketable to public capital markets. This model has led to remarkable returns to compensate for the high level of risk, and resulted in a highly competitive and innovative economy.
What Problem Does Venture Capital Solve?
The purpose of venture capital is to finance entrepreneurial business ventures when the endeavor presents too much risk for other forms of finance. In order to provide investors with enough return on their investment, they get an equity share in the company that has the potential of increasing in value in large multiples over their initial investment.
As companies start out, they do not meet the criteria for financing by conventional sources. In their early stages, private businesses or ideas for businesses do not have a track record of success, even if the idea is good. There is a high rate of failure among these startups so there is no telling which ideas will succeed or fail. Banks and capital markets would not accept the risk of financing an unproven business model.
Fortunately, the opportunity was recognized by venture capitalists that there are inherent successes among these fledgling businesses. The first problems was judging which businesses had a probability of success. The second problem was the need for these companies to access capital to sustain their growth until they could become attractive to public capital markets and other forms of conventional finance. There would have to be an investment model to realize greater returns to compensate for the risk.
The solution was to investigate startups and then invest early in these companies for an equity stake. Additional rounds of raising equity capital could follow as the business venture grew and became more established. With their knowledge and experience, venture capitalists could also provide guidance and insight to entrepreneurs to help increase their chances of success. Eventually the company could qualify for an IPO and the equity could be traded or valued on public markets at enormous returns on their investment. The success of this venture capital model has lead to a highly evolved system that continues to fuel innovation.
Stages of Raising Venture Capital
When a budding company begins, it will need seed money. This is the first stage of raising capital for the enterprise. At this point, the company may be too small for venture capital. Angel investors, who are smaller individuals who capitalize a startup for an equity share may be appropriate to move the entrepreneurial effort forward. Furthermore, the right angel will shepherd the company forward through expertise and networking.
When the company has begun to establish itself, its capital needs will progress in parallel to the needs of the growth of the business. In venture capital terms, these stages of growth correspond to Series A, Series B, and Series C rounds of raising capital.
Series A may occur when the company begins to generate revenue. As the company establishes serious revenue, an additional round of raising capital may occur through a Series B funding. As the company reaches a critical mass before going public, an additional Series C funding can occur.
Risk And Reward In Venture Capital
As the company evolves, less and less equity will be available for investors. The result is each investment at each progressive stage of investment yields less return for the investors. This is understandable. As the business becomes more established and its revenue grows, it poses less risk to investors, and hence less return.
The Risks Of Venture Capital To The Entrepreneur
Although the risk versus reward principle holds true as the business becomes established, there is always a factor of human error involved. Human error can arise during negotiations as entrepreneurs negotiate with angels and venture capitalists.
Entrepreneurs should be cautious NOT to give up too much equity in the early stages of their company so they can have enough equity to raise additional capital through the subsequent stages of their company's growth. They should ration their equity conservatively to investors. They should maintain cost discipline and not raise more capital than needed to retain as much equity as possible.
The consequences of not rationing the equity of their company can be disastrous to both the entrepreneur and investors alike. Investors need to have confidence that their investment in the company will not be diluted. Both entrepreneurs and investors also need to know there are options to raise additional capital if it is needed.
Equally important, entrepreneurs can lose control of their endeavor to others who may have different goals and interests. Loss of control can lead to conflict, loss of vision, and loss of good will among the parties.