What Is Venture Capital: How Does It Work and Its Importance for Startups?
This article contains a comprehensive overview of the field of Venture Capital, including its history, key players, investment strategies, and future outlook. It explores the different stages of venture funding, from seed funding to Series A, B, and beyond. Additionally, it covers the various types of VC firms, such as corporate venture capital and angel investors. The document also delves into the due diligence process, analyzing how VC firms evaluate potential investments and what factors they consider when making investment decisions. Finally, it examines the latest trends and challenges facing the Venture Capital industry, including the impact of COVID-19, the rise of alternative funding sources.
What Is Venture Capital (VC)?
Venture capital (VC) is a sort of private equity and finance provided by investors to start-ups and small firms that are expected to develop over time. Wealthy individuals, investment banks, and other financial institutions are the most common sources of venture capital. Venture capital does not necessarily have to be monetary. In reality, it frequently manifests as technical or managerial knowledge. VC is often awarded to small businesses with excellent growth potential or to those that are rapidly growing and look to be ready to develop further.
KEY TAKEAWAYS
- The word “venture capital” refers to finance offered to enterprises and entrepreneurs.
- Venture capitalists can give financial support, technology competence, and/or management experience.
- Venture capital can be supplied at many phases of development; however, it is most commonly used for early and seed round investment.
- Venture capital funds handle pooled investments in high-growth possibilities in startups and other early-stage companies, and they are often only available to authorized investors.
- Venture capital grew from a niche activity after World War II to a complex business with several participants who played a vital role in prompt innovation.
Understanding venture capital (VC)
As we’ve already discussed, VC gives funding to startups and small businesses that investors perceive to have significant development potential. Financing is often provided in the form of private equity (PE), although it may also take the form of knowledge, such as technical or managerial expertise.
VC deals often include the establishment of huge ownership chunks of a firm, which are sold to a few investors via independent limited partnerships. These ties are formed by venture capital companies and may include a group of similar companies.
One significant distinction between venture capital and other private equity deals is that venture capital focuses on emerging companies seeking significant funds for the first time, whereas PE funds larger, more established companies seeking an equity infusion or the opportunity for company founders to transfer some of their ownership stakes.
Venture capitalists are typically attracted to opportunities that offer above-average returns, despite the risks involved. For new businesses or projects with a short operating history (less than two years), venture capital is becoming an increasingly popular and necessary source of funding, particularly if they lack access to capital markets, bank loans, or other debt instruments. However, one major drawback of venture capital is that investors often receive shares in the firm, thereby having a say in business decisions.
The biggest disadvantage is that investors often receive shares in the firm and so have a role in business decisions.
A History of Venture Capital
Private equity has a subclass called venture capital. While PE has origins dating back to the nineteenth century, VC emerged as an industry after World War II.
George Doriot, a Harvard Business School professor, is widely regarded as the “Father of Venture Capital.” In 1946, he founded the American Research and Development Corporation and funded $3.58 million to invest in firms that utilized WWII technologies.
The corporation’s initial investment was in a startup with plans to employ X-ray technology to cure cancer. Doriot’s $200,000 investment turned into $1.8 million when the business went public in 1955.
Hit From the 2007–2008 Financial Crisis
The financial crisis of 2007–2008 influenced the venture capital business. Venture capitalists and other institutional investors, who provided funding for many startups and small businesses, tightened their purse strings.
The advent of the unicorn marked a shift in the aftermath of the Great Recession. A unicorn is a private startup with a valuation of more than $1 billion.
These enterprises began to attract a varied group of investors seeking high returns in a low-interest-rate environment, including sovereign wealth funds (SWFs) and prominent private equity firms. Their arrival caused changes to the venture capital ecosystem.
Westward Expansion
Although it was initially backed mostly by Northeastern banks, venture capital became focused on the West Coast as the tech sector expanded. Fairchild Semiconductor was founded by eight engineers (the “traitorous eight”) from William Shockley’s Semiconductor Laboratory and is often regarded as the first technological firm to obtain venture capital support. Sherman Fairchild, an East Coast businessman from Fairchild Camera & Instrument Corp., provided the funding.
Arthur Rock played a key role in enabling the deal between Intel and Apple as an investment banker at Hayden, Stone & Co. in New York City. Later, he co-founded one of the first VC firms in Silicon Valley, Davis & Rock, which provided financial support to some of the most influential technology companies such as Intel and Apple.
In 1992, the West Coast companies received 48% of all investment dollars, while Northeast Coast industries received just 20%.
Even today, according to Pitchbook and the National Venture Capital Association, the situation has not changed much. During 2022, although West Coast companies accounted for more than 37% of all deals (but about 48% of deal value), the Mid-Atlantic region saw just around 24% of all deals (and approximately 18% of all deal value).
In the year 2022, companies in the United States that were backed by venture capitalists managed to raise a whopping $160 billion in funding. This significant amount of capital infusion indicates strong investor confidence in the potential of these companies to grow and generate impressive returns on investment.
Help from Regulations
A succession of legislative developments helped promote venture capital as a funding channel. The first was an alteration in the Small Business Investment Act (SBIC) in 1958. It strengthened the VC business by offering tax advantages to investors. In 1978, the Revenue Act was changed to lower the capital gains tax from 49% to 28%.
Then, in 1979, a modification in the Employee Retirement Income Security Act (ERISA) enabled pension funds to invest up to 10% of their assets in small or new firms. This action prompted a surge of investments from wealthy pension funds. The capital gains tax was decreased to 20% in 1981.
These three innovations accelerated VC growth, and the 1980s became a golden time for venture capital, with funding reaching $4.9 billion in 1987.
The dot-com bubble also placed the business into sharp focus, as venture investors sought rapid profits on highly valued internet-based businesses.
Based on some estimates, financing levels reached up to $30 billion over that time period. Wall Street Mojo: “Dotcom Bubble.”
However, the anticipated returns were not fulfilled as numerous publicly-listed internet companies with enormous valuations collapsed and burned their way to bankruptcy.
The benefits and drawbacks of venture capital
Venture capital offers finance to emerging enterprises that do not have access to the stock market or sufficient cash flow to take on debt. This arrangement may be mutually advantageous since firms receive the funding, they require to begin operations, while investors earn shares in potential enterprises.
There are other advantages to a VC investment. In addition to investing funds, venture capitalists frequently give mentorship and networking services to assist growing firms in establishing themselves and finding talent and fund. Strong VC support might lead to more investments.
A company that takes VC funding, on the other hand, risks losing creative control over its future course. VC investors are likely to seek a big portion of the company’s stock, and they may also make demands on the company’s management. Many venture capitalists are just interested in making a short, high-return investment and may put pressure on the firm to exit quickly.
Pros
- Assists early-stage enterprises with funding to establish operations.
- Companies do not require cash flow or assets to get VC funding.
- VC-backed mentorship and networking services assist emerging businesses gain talent and development.
Cons
- Requires a significant part of firm stock.
- Companies may lose creative autonomy as investors expect rapid profits.
- Venture capitalists may urge firms to exit investments rather than pursue long-term growth.
Different Types of Venture Capital:
Venture capital is widely classified according to the growth stage of the firm receiving the investment. Generally, the younger a firm is, the higher the risk for investors.
The different stages of Venture Capital investing are as follows:
- Pre-Seed: This is the first stage of business creation in which the founders attempt to transform a concept into a tangible business strategy. They may join a startup accelerator to get early investment and guidance.
- Seed Funding: This is used by emerging businesses to launch their initial product. Because currently there are no income sources, the firm will rely entirely on venture capitalists to support its operations.
- Early-Stage Funding: Once a company has produced a product, it will require more investment to ramp up manufacturing and sales before becoming self-sufficient. The company will subsequently require one or more investment rounds, often indicated as Series A, Series B, and so on.
