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What Is Venture Capital?

Venture capital is money provided by an outside investor to finance a new, growing, or troubled business.

The venture capitalist provides the funding knowing that there’s a significant risk associated with the company’s future profits and cash flow. Capital is invested in exchange for an equity stake in the business rather than given as a loan, and the investor hopes the investment will yield a better-than-average return.

Venture capital is an important source of funding for start-up and other companies that have a limited operating history and don’t have access to capital markets. A venture capital firm (VC) typically looks for new and small businesses with a perceived long-term growth potential that will result in a large payout for investors.

Who is a Venture Capitalist?

A venture capitalist is not necessarily just one wealthy financier. Most VCs are limited partnerships that have a fund of pooled investment capital with which to invest in a number of companies. They vary in size from firms that manage just a few million dollars worth of investments to much larger VCs that may have billions of dollars invested in companies all over the world. VCs may be a small group of investors or an affiliate or subsidiary of a large commercial bank, investment bank, or insurance company that makes investments on behalf clients of the parent company or outside investors. In any case, the VC aims to use its business knowledge, experience and expertise to fund and nurture companies that will yield a substantial return on the VC’s investment, generally within three to seven years.

Returns for Investors

Not all VC investments pay off. The failure rate can be quite high, and in fact, anywhere from 20 percent to 90 percent of portfolio companies may fail to return on the VC’s investment. On the other hand, if a VC does well, a fund can offer returns of 300 to 1,000 percent.

Partnership

In additional to a portion of the equity, a VC expects to have a say in how its portfolio company operates. Ideally, the VC fosters growth at the company through its involvement in managerial, strategic, and planning decisions. To do this, the VC relies on the expertise of its general partners who may be former CEOs, bankers, or experts in a particular industry. In most cases, one or more general partners of the VC take Board of Director positions at a portfolio company. They may also help recruit key executives to the portfolio company.

Size of Funding

It’s important to do your homework before approaching a VC for funding, to make sure you’re targeting the right potential partner for your business needs. Not all VCs invest in ‘start-ups.’ While some may invest small amounts of “seed” capital for very early ventures, many focus on early or expansion funding, while still others may invest at the end of the business cycle, specializing in buyouts, turnarounds, or recapitalizations.

Investment Preferences

VCs may be generalists that invest in a variety of industries and locations. More typically, they specialize in a particular industry. Make sure your company falls within the VC’s target industry before you make your pitch – a VC that’s focused on biotechnology start-ups will not consider your request for later-stage funding for expansion of your semiconductor firm. You can often gain insight into a VC’s investment preferences by reviewing its website.

In addition to industry preferences, VCs also typically have a geographic preference. Being in the same general location as a portfolio company allows the VC to better assist with business operations such as marketing, personnel, and financing.

Keep in mind that venture capital is not an option for all new businesses. In fact, VCs are very selective in choosing new companies to invest in, so your company may not qualify. They’re most interested in businesses with high growth potential that will allow them to successfully exit with a higher than average return in a time frame of roughly three to 10 years, depending on the type of investment.

Given the rigorous expectations, most venture funding goes to companies in rapidly expanding industries such as technology, biotechnology, and life sciences.