Venture Capital

Defining Venture Capital

Early-stage business ventures gain funding and guidance from venture capitalists in exchange for an equity stake in the firm.

Learning Objectives

Describe how the venture capital process works

Key Takeaways

Key Points

  • Venture capital is the financial capital provided to early-stage high-potential start-ups unable to acquire the necessary funding through conventional means.
  • For venture capitalists, the high risk of investing is offset by the potential of high returns.
  • Venture capitalists typically spread out their fund over a number of investments so that returns from successful investments will outweigh the losses from failed ventures.
  • Venture capitalists take an active role in a company’s performance; guidance, expertise, and industry connections can be just as valuable as financial capital.

Key Terms

  • venture capital: Money invested in an innovative enterprise in which both the potential for profit and the risk of loss are considerable.
  • Initial public offering: An initial public offering (IPO) or stock market launch is a type of public offering where shares of stock in a company are sold to the general public.

Venture capital is a method of financing a business start-up in exchange for an equity stake in the firm. The risk of investment loss and the potential for future payout are both very high. As a shareholder, the venture capitalist’s return is dependent on the growth and profitability of the business. Return is earned when the business is sold to another owner or it “goes public” with an initial public offering (IPO). The venture capitalist can then “exit” by selling his shareholdings in the company.

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Venture capital funds revolutionary social networking services: Facebook is one example of a entrepreneurial idea that benefited from venture capital financing. The Menlo Park-based firm has seen immense success since their launch in 2004. Unfortunately for Facebook’s venture capitalist investors (Accel Partners, Greylock Partners and Meritech Capital), the IPO has not performed as well as expected.

Due to their risky nature, most venture capital investments are done with pooled investment vehicles. Investors combine their financial contributions into one fund, which is then used to invest in a number of companies. This way, investors are diversifying their portfolio and spreading out risk. Venture capitalists are gambling that returns from successful investments will outweigh investments lost in failed ventures. Venture capitalists are selective in their investments. Innovative technology, growth potential and a well-developed business model are among the qualities they look for. Growth potential is the most important quality, given the high risk a VC firm assumes by investing. The priority for VC firms is high financial return and a successful exit within three to seven years.Venture funding is most suitable for businesses having large up-front capital requirements that cannot be financed by debt or other alternatives. These characteristics usually best fit companies in high-tech industries, which explains the venture capital boom of the late 1990s. The technology firms of Silicon Valley and Menlo Park were primarily funded by venture capital. These industries saw a surge in public interest that eventually generated large returns for VC firms.

A VC firm’s contributions often extend beyond financial funding. To increase the likelihood of high returns, it is in the venture capitalists’ interests to nurture their investments. Any guidance and expertise venture capitalists offer to start-up firms can be instrumental to success.

Advantages and Disadvantages of VC Financing

While VC financing provides the benefit of significant resources, costs include loss of ownership and autonomy.

Learning Objectives

Discuss the advantages and disadvantages of using venture capital

Key Takeaways

Key Points

  • With VC financing, companies can acquire large sums of capital that would not be possible through bank loans or other conventional methods.
  • Venture capitalists provide expertise and industry connections that can be extremely valuable.
  • Accounting and legal costs make securing a VC deal a difficult process. If a deal is secured, VC investors will be highly involved in deciding on the company’s strategic direction.

Key Terms

  • venture capital: Money invested in an innovative enterprise in which both the potential for profit and the risk of loss are considerable.
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Weighing advantages and disadvantages: Pursuing venture capital financing may not be appropriate for most start-up companies. It is important to weigh the benefits of receiving abundant resources against the costs of losing autonomy and ownership.

Advantages: The primary advantage of venture capital financing is an ability for company expansion that would not be possible through bank loans or other methods. This is essential for start-ups with limited operating histories and high upfront costs. In addition, repayment of VC investors isn’t necessarily an obligation like it would be for a bank loan. Rather, investors are shouldering the investment risk because they believe in the company’s future success.

In addition to financial capital, venture capitalists provide valuable expertise, advice and industry connections. A stipulation of many VC deals includes appointing a venture capitalist as a member of the company’s board. This way, the VC firm has intimate involvement in the direction of the company.

Venture capital is also associated with job creation (accounting for 2% of US GDP), the knowledge economy, and used as a proxy measure of innovation within an economic sector or geography.

Disadvantages: Securing a VC deal can be a difficult process due to accounting and legal costs a firm must shoulder. The start-up company must also give up some ownership stake to the VC company investing in it. This results in a partial loss of autonomy that finds venture capitalists involved in decision-making processes. VC deals also come with stipulations and restrictions in composition of the start-up’s management team, employee salary and other factors. Furthermore, with the VC firm literally invested in the company’s success, all business operations will be under constant scrutiny. The loss of control varies depending on the terms of the VC deal.

IPOs

Initial public offerings are a primary and potentially lucrative means of exit from investment for venture capitalists.

Learning Objectives

Describe the benefits and disadvantages of an IPO

Key Takeaways

Key Points

  • An initial public offering is the first time a company’s stock is sold to the general public on a securities exchange, transforming the company from private to public. Though unpredictable and potentially costly, IPOs give benefits like increased access to financial markets and more capital.
  • Venture capitalists gain both financial returns and professional reputation from successful IPOs.
  • For venture-backed companies, their VC investors often expect the company to go public within a certain time frame so that they can sell or distribute their holdings of the company and exit the investment.
  • Venture capitalists protect their ability to sell shares by contracting for registration rights prior to agreeing on funding the company. Demand rights allow the investors to initiate an IPO, while piggyback rights allow investors to sell when the company initiates an IPO.
  • If the IPO market is weak, this threatens the venture capitalists’ chances of a successful exit. The VC investors may instead select a different method of exit, or they can wait and hope for the market to improve.

Key Terms

  • Initial public offering: An initial public offering (IPO) or stock market launch is a type of public offering where shares of stock in a company are sold to the general public.
  • Registration rights: A contractual agreement specifying conditions for registering shares of stock with the SEC prior to selling them on a security exchange.

An initial public offering (IPO), also known as a stock market launch, is the first time a private company’s shares are sold to the general public on a securities exchange. Allowing the general public to take up equity stakes in the company transforms it from being privately traded to publicly traded. If the company was venture-backed, the VC firms often gain their returns from IPO yields. Usually, the VC exits investments within a short time (1-3 years, normally) after the IPO is concluded either by distributing the shares to VC fund investors or selling them off on the market. Going public can also have benefits for the company, including:

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Apple Computers IPO Prospectus: The Initial Public Offering (IPO) Prospectus for Apple Computer Inc. in December 1980. A total of 5 million shares were offered to the public for $22 each. The total outstanding shares after the offering were 54,215,332. The company’s officers, directors and major shareholders held 32 million shares and the rest were held by the company for stock options plans and other needs. Apple’s valuation after the IPO was over $1 billion. (54 million shares at $22. )

  • Increasing exposure, prestige, and public image
  • Enlarging and diversifying equity base
  • Enabling cheaper access to capital, which is particularly important for high growth companies
  • Allowing owners of the company to cash in on their efforts in a very lucrative way (if the IPO is successful).
  • Attracting and retaining better management and employees through liquid equity participation

IPOs are not without cost to the company. Disadvantages to completing an initial public offering, include:

  • Legal, accounting and marketing costs associated with the process
  • Requirement to disclose financial and business information
  • Meaningful time, effort and attention required of senior management
  • Risk that required funding will not be raised
  • Public dissemination of information which may be useful to competitors, suppliers and customers.

Prior to agreeing to provide capital, venture capitalists contract for privileges including “registration rights”, which ensure their ability to sell shares into the public capital markets, thereby safeguarding their future returns. Prior to selling shares on the stock exchange, companies must register these shares with the Securities and Exchange Commission. The registration rights agreement between the company and the venture capitalists requires the company to register the offering of shares by venture capitalists under certain conditions.

These conditions may be in the form of “demand rights” or “piggyback rights”.

  • Demand rights require the company itself to prepare, file and maintain a registration statement on behalf of the investors’ shares, so that investors can actually initiate a public offering and sell their shares.
  • Piggyback rights require that the VC investors’ shareholdings are included in a company-initiated registration, so that the investors can sell their shares when the company initiates a public offering. The number of each type of demand or piggyback rights, the percentage of investors necessary to exercise these rights, allocation of expenses of registration, the minimum size of the offering, the scope of indemnification and the selection of underwriters and brokers are all areas of potential negotiation in the registration rights agreement.