A venture capitalist is a person or company that invests in a business venture, providing capital for startup or expansion. However, individual venture capitalists are a rarity; the majority of venture capital (VC) comes from professionally managed public or private firms. Their business is to pool investment funds from various sources and find and invest in businesses that are likely to provide their investors with high rates of return.
Because venture capital firms want higher return rates than other investments, such as the stock market, provide, they typically invest in promising startup or young businesses that have a high potential for growth but are also high risk. Venture capital firms typically invest in business sectors such as IT, bio-pharmaceuticals, clean technologies, semiconductors, etc.
Why Businesses Look for Venture Capitalists
An investment from a venture capitalist is a form of equity financing: The VC investor supplies funding in exchange for taking an equity position in the company. Equity financing is normally used by nonestablished businesses that are unable to secure business loans from financial institutions (debt financing) because of insufficient cash flow, lack of collateral, or a high-risk profile.
A company may also solicit the participation of venture capitalists due to the need for additional business expertise.
For example, in 1981 Bill Gates decided that Microsoft needed strategic thinking and sound advice from an experienced businessperson, and he was able to convince venture capitalist Dave Marquardt to invest in Microsoft and join the board of directors, even though Microsoft was not in need of investment capital at the time.
As it turned out, Dave Marquardt was the only venture capitalist ever to invest in Microsoft, and he remained on Microsoft’s board for more than 30 years.
How Venture Capital Firms Work
Venture capital investments in businesses are typically for the long term (the average is from five to eight years). This is normally how long it takes for a young business to mature to the point where its equity shares have value and the company goes public or is bought out. VC firms expect returns on investment of 25 percent or greater, given the risk profile of the companies they invest in.
Venture capital firms obtain investment capital by pooling money from pension funds, insurance companies, wealthy investors, and the like. The firm makes the decisions about which businesses to invest in and receives management fees and a percentage of the profits as compensation.
VC firms range in size from small (capital pools of a few million dollars, typically investing in only a few new businesses each year) to huge (billions of dollars in assets and invested in hundreds of companies).
Who Has Control of the Company?
Venture capital financing is a poor choice for entrepreneurs who want to retain control of their businesses.
In exchange for providing funding, most VC firms obtain majority voting rights by having the majority of the shares (or a preferred class of shares that are senior to common shares), as well as special veto rights. And venture capitalist investments are often structured so that in the case of a share sale, the VC investors have priority rights in terms of compensation.
To additionally safeguard their investments, VC firms take an active role in the businesses they invest in, typically supplying a board member and involving themselves in all important management decisions, including exercising veto rights over such issues as the sale of the company, additional financing, and major business expenditures.
How Hard Is It to Get VC Funding?
The vast majority of businesses don’t qualify for venture capital funding.