Venture Capital

Definition: Funds flowing into a company, generally during pre-IPO process, in the form of an investment rather than a loan. Controlled by an individual or small group known as venture capitalists, these investments require a high rate of return and are secured by a substantial ownership position in the business.

Venture capitalists (VCs) represent the most glamorous and appealing form of financing to many entrepreneurs. They're known for backing high-growth companies in the early stages, and many of the best-known entrepreneurial success stories owe their growth to financing from venture capitalists.

VCs can provide large sums of money, advice and prestige by their mere presence. Just the fact that you've obtained venture capital backing means your business has, in venture capitalists' eyes, at least, considerable potential for rapid and profitable growth.

VCs make loans to--and equity investments in--young companies. The loans are often expensive, carrying rates of up to 20 percent. Many venture capitalists seek very high rates; a 30 percent to 50 percent annual rate of return. Unlike banks and other lenders, venture capitalists frequently take equity positions as well. That means you don't have to pay out hard-to-get cash in the form of interest and principal installments. Instead, you give a portion of your or other owners' interest in the company in exchange for the VCs' backing.

The catch is that often you have to give up a large portion of your company to get the money. In fact, VC financiers so frequently wrest majority control from and then oust the founding entrepreneurs that they are sometimes known as "vulture capitalists." But VCs come in all sizes and varieties, and they're not all bad.

Venture capitalists typically invest in companies they anticipate being sold either to the public or to larger firms within the next several years. Companies they will consider investing in usually have the following features:

  • Rapid, steady sales growth
  • A proprietary new technology or dominant position in an emerging market
  • A sound management team
  • The potential for being acquired by a larger company or taken public in a stock offering

In addition, venture capitalists often define their investments by the business' life cycle: seed financing, start-up financing, second-stage financing, bridge financing, and leveraged buyout. Some venture capitalists prefer to invest in firms only during start-up, where the risk is highest but so is the potential for return. Other venture capital firms deal only with second-stage financing for expansion purposes or bridge financing where they supply capital for growth until the company goes public. Finally, there are venture capital companies that concentrate solely on supplying funds for management-led buyouts.

There are several types of venture capital:

Private venture capital partnerships are perhaps the largest source of risk capital and generally look for businesses that have the capability to generate a 30 percent return on investment each year. They like to actively participate in the planning and management of the businesses they finance and have very large capital bases--up to $500 million--to invest at all stages.

Industrial venture capital pools usually focus on funding firms that have a high likelihood of success, like high-tech firms or companies using state-of-the-art technology in a unique manner.

Investment banking firms traditionally provide expansion capital by selling a company's stock to public and private equity investors. Some also have formed their own venture capital divisions to provide risk capital for expansion and early-stage financing.

The way to contact venture capitalists is through an introduction from another business owner, banker, attorney, or other professional who knows you and the venture capitalist well enough to approach them with the proposition.

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