Although I’ve observed the venture capital industry at work for most of my career and have invested in lots of companies making their first move away from private equity financing, I’ve never actually worked in the venture capital industry. So this post will be brief.
Venture capital is a form of private equity financing. VCs support early-stage companies that they think have substantial growth potential, but which are too small, and too risky, to get conventional bank financing. Their small size and immature businesses also rule out the possibility of a conventional IPO. Again, the risk it too high. In addition, if the company wants to raise, say, $10 million, fee income would at most be $1 million–too little to interest most reputable investment banks. (The only time I can recall seeing brokerage houses reaching down into venture capital territory in a big way was in the latter days of the internet bubble in 1998-99–and we all know how that turned out.)
In the US, venture capital is typically associated with Silicon Valley in California. In their search for start-ups with explosive growth potential, they have acquired deep knowledge of technology-related industries (where that potential resides) and of skilled entrepreneurs who can turn that potential into a fast-growing firm. So they feel comfortable there.
VC activity isn’t always in the tech world. But you won’t see venture capitalists backing firms in, say, furniture retailing, where it’s difficult to see earning several times your initial investment in a reasonable period of time.
Venture capital financing isn’t a one-shot deal. It typically occurs in a number of stages, or “rounds,” where a company gets more money, so it can move to a higher level of development.
Stages might correspond to company needs for:
–seed money, where the VC firm supplements funds committed by the entrepreneurs themselves, or their friends and family.
–manufacturing and marketing
If everything is going smoothly, each round of funding will be at a higher stock price. The funding may be done through convertible securities rather than straight equity. This gives the venture capitalist some income while he waits for the company to mature. Convertibles can also give the VC a stronger claim on company assets than ordinary equity holders in the case that things go badly.
The venture capitalist has traditionally expected to cash out of the company he has invested in thorough a conventional IPO–at which time he will have the option of selling some or all of his shares. In today’s world, however, it’s equally possible that a private sale to a much larger firm in the same industry will happen instead.
Venture capitalists are willing to invest in companies at a much earlier stage of development than others.
VCs also typically provide organizational help, management and technical expertise that may be sorely needed by a fledgling company but which may not be available any other way.
If you don’t have stellar growth potential, VCs probably aren’t interested. Simply getting their money back, with interest, isn’t enough.
At some point, usually very early on, part of the price for additional financing will be that the entrepreneurs cede control of the business to the VCs. In most cases, this is probably a good thing, since risk-taking visionaries don’t often make great managers (look at the early Steve Jobs).
That’s it for today. More tomorrow.