Venture Capital is a type of equity financing that pools money from investors to finance startups and small companies before they have started earning revenues. These funds primarily focus on small companies with high growth potential and require capital for their development and operations.
Venture capital funds are fundamentally different from mutual funds or hedge funds as they focus on a specific type of early-stage investment. All startups that receive venture fund investments have high growth potential and a long investment horizon. The venture investors take on an active role in the startups by providing guidance and often taking a seat on the board.
But how do you invest in venture capital funds? In this article, we will discuss what are VCs, how to invest in VCs, and what are the different types of venture capital funds.
Let’s get started.
Understanding Venture Capital
As mentioned above, venture capital provides equity financing to small companies with high growth potential and requires funds for their development and growth. This type of financing usually comes in the form of private equity or some form of expertise like guidance or managerial skills.
However, a stark difference exists between venture capital investments and private equity. While VC focuses on emerging companies requiring substantial funding for the first time, private equity(PE) tends to fund larger established companies looking for equity infusion.
In venture capital investments, large ownership chunks of a company are created and sold to investors through independent limited partnerships. This is usually done by a venture capital firm and consists of a group of several enterprises of a similar industry.
While VC involves considerable risk, the potential of above-average returns is highly lucrative and attracts investors towards venture capital. VC is becoming an increasingly popular source of raising funding for small companies with a limited operating history(under two years), especially if they have no other form of capital like bank loans, capital markets, etc.
However, one of the drawbacks of venture capital investments is that investors usually get large equity shares in the company, and therefore, a say in company decisions.
Life Cycle of a Venture Capital Fund
If you want to invest in venture capital funds, you must understand the life cycle of VCs and how they work. Generally, VCs progress through four stages in their life cycle. Let’s understand.
Fundraising
In the fundraising stage, the VC fund will create its partnership structure, finalize strategies, and try to find investors. During this possess, the general partner(GP) will research and identify potential investors, setting up its company, and creating a team.
Investment
In the investment stage, the GP finalises the targets for investment, arranges a meeting with the founders, and evaluates the potential of investment. Once the GP has done its due diligence, the venture capital fund will invest in the selected companies.
Value Creation
In this stage, the GP tracks its investments, connects with the target companies, and offers guidance whenever needed. While VC funds don’t assume managerial roles in their investments, the GPs work with the founders and management team at a strategic level for the growth of the company and their investment.
Exits
In the exit stage, the GPs work with the companies to arrange an exit to return the invested capital in the form of distributions. Exits are usually in the form of IPOs, acquisitions, or secondary sales to other investors. However, there are many uncertainties surrounding exits, which is why, the holding period for VC funds tends to be longer than other private equity investment vehicles.
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Types of Venture Capital Investments
Depending on the growth stage of the company receiving the investment, venture capital investments can be categorized into three types. It is important to remember that, the younger the company, the greater the risk for investors.
Here are the types of VC investments-
Pre-Seed
The earliest stage of a company is when founders try to transform their idea into a concrete business with workflow and operations. Pre-seed companies may enroll in a business accelerator to secure early funding.
Seed Funding
In this stage, the company seeks to launch its first product. However, as the company doesn’t have any active revenue streams yet, they look for VCs to fund their operations.
Early-Stage Funding
Once a company has developed a product, it requires more capital to start bulk production and sales. The business then requires one or more funding rounds, called Series A, Series B, etc.
The Pros and Cons of Venture Capital
Venture capital provides funding to small businesses that do not have access to stock markets or other forms of funding. This arrangement is a win-win as companies get funding and investors get equity stakes in companies with high growth potential.
Besides funding, VCs also offer guidance and mentoring to small companies to help establish themselves. However, a business that takes on VC support can lose creative control as venture capitalists get an ownership stake and a say in the company’s decisions.
Most VCs only invest in a company to make a fast, high-return payoff and may pressure the company for an early exit.
| Pros | Cons |
| Provides capital to early-stage companies with no access to other funding methods. | Demands a large share of the company’s equity |
| Companies generally don’t need an active revenue stream or assets to secure VC funding/. | Companies may lose creative control as VCs get private equity and a say in the company’s decisions. |
| VC-backed guidance and networking can help companies secure talent. | VCs may pressure companies for quick exits instead of pursuing long-term growth. |
Venture Capital vs Angel Investors
Venture capital is provided by high-net-worth individuals(HNIs), known as venture capital firms or angel investors. The National Venture Capital Association is an organization consisting of several venture capital firms that provide funding to startups and small businesses.
On the other hand, angel investors are high-net-worth individuals who have amassed their wealth through different sources. They are generally entrepreneurs or retired senior executives from the businesses they have built.
Most VCs typically share several characteristics. The majority of them seek out companies that have a fully developed business plan and have high growth potential. These investors prefer funding businesses in their own industries or business sectors they are familiar with.
When it comes to angel investors, co-investing is a popular trend. It is when one angel investor funds a venture along with a trusted associate, who is also an angel investor.
Exit Strategies on Venture Capital Investments
Unlike bonds or stocks, returns on venture capital investments are generated when a position is exited. Here are the three most common ways for VCs to exit.
Direct Share Sale
The VC fund sells its shares in the company to another investor or the company itself.
Acquisitions
Another large company buys the investment company and in doing so buys out the venture capital fund.
Initial Public Offering(IPO)
When a company launches an IPO, it goes public and the venture capital sells its shares in the investment company.
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Key Takeaways
- Venture capital is the financing provided to small companies and entrepreneurs to kickstart their businesses.
- Venture capitalists help small businesses through capital financing, technological expertise, networking connections, and managerial experience.
- VC can be provided at different stages of a company’s evolution, however, most commonly, it is provided at early and seed funding.
- Venture capitalists target high-growth companies that often involve risk. As a result, they are only available to accredited investors that are capable of handling losses.
- Investors in VC funds earn a return when the investment company exits, either through acquisition, merger, or IPO.
Frequently Asked Questions(FAQs)
Ans. Venture capital falls under the private equity umbrella. Besides VC, private equity also includes private placements, leveraged buyouts, etc.
Ans. While this may largely depend on the venture capitalist, how much they invest, and the relationship between the founder and investor, VCs generally take 25% to 50% of a company’s ownership.
Ans. Starting a new business is a risky and cost-intensive venture. As a result, capital from external sources is required to start and manage operations. Venture capitalists take on this highly risky venture in return for obtaining equity and voting rights on a promising company. Therefore, allowing the startup to get off the ground.
