Venture Capital
VENTURE CAPITAL
Venture Capital, in simple terms, is investing in small expanding businesses with typically high growth potential.
Scaling up a small business over a short amount of time can consume the business’ entire starting capital along with its net profits, if any. This challenge can pose a risk of bankruptcy to even some of the potentially most valuable businesses in their early stages. This is where Venture Capital comes in as a solution. In exchange for waiving a typically-large percentage of ownership in the business, the business owner receives a typically-large amount of capital to be used in growing the business and covering the expenses. The expenses that are associated with growing include hiring, better offices, marketing, advertising, improving services or ordering goods in large quantities, and offering discounts to retain loyal customers.
The defining characteristics of Venture Capital are:
1) It is a form of private equity: Venture capital is an investment made into a company that is not publicly traded.
2) It is typically a high-risk-high-reward investment: Investing early on in a small business with big potential can have a high yield, but the risk of failure for small businesses is significantly higher compared to large, established businesses. In venture capital, it is typical that the invested business loses money for a certain period of time, burning through the invested amount while trying to scale up, before turning a net profit.
3) It is reserved for businesses in early stages: Venture capital by definition is to invest in a small business that has not reached its potential yet. The advantage of investing early on is that, due to the relatively low valuation of the business, the investor receives a larger share for the same investment amount than they would have received had they waited for the business to grow before investing.
In short, Venture Capital is a risky but rewarding investment opportunity for sophisticated investors who prefer such investments.
The defining characteristics of a Venture Capitalist are:
1) A venture capitalist is a business professional who invests on behalf of a risk capital company. In other words, a venture capitalist invests other investors’ funds, as opposed to an angel investor who invests his own money on his own behalf.
2) A venture capitalist is a sophisticated investor who is well-versed in business and finance. Venture capitalists calculate the risks and typically mitigate them by diversifying their portfolio of small businesses.
Venture Capital is sometimes a necessity for business owners despite costing them typically a large control and ownership in the company.
The key characteristics of a small business that is suitable for Venture Capital is;
1) Profitable business model: Without the right business model, a business is doomed to fail regardless of how good its goods/services are and how much it can potentially grow its revenues.
2) High growth potential: In order for Venture Capital to be feasible, the business must have high growth potential so that it can actually use the capital injection to increase its revenues and return the investment to the investor as soon as possible.
3) Competent business owner/manager: A business owner/manager with the qualifications to competently run the business is a vital part of Venture Capital. Otherwise, the investor would have to hire qualified professionals in all top positions and the investment would be spent on management rather than other more important areas such as marketing, advertising, etc.
4) An urgency to grow it to a large scale over a short period of time: Venture Capital is reserved for businesses that require capital as part of a valid, realistic business strategy such as; pricing competitively in order to retain loyal customers, and growing as quickly as possible in order to control a larger share of the market than current and potential competitors.
5) Limited capital (or the lack thereof): Venture Capital is needed only if the founder is in need of more capital. Therefore, subsidiaries of large businesses are not suitable for Venture Capital, as these large businesses typically do not prefer to part with large ownership in exchange for capital, since they can afford to fund the business without outside investors.
Venture Capital vs Company Acquisition
Venture Capital is often confused with acquiring a portion of a company because both are essentially investing in a business. However, venture capital and company acquisition are fundamentally different investments for the reasons below:
1) In an investment in the form of Venture capital, the company issues new shares that are in turn acquired by the Venture Capital investors. This way, the investment amount goes to the company itself, not to the owner of the company, and has to be spent on the business just like the starting capital of the company.
By issuing new shares and increasing the capital of the company, the founder’s ownership percentage is diluted despite the founder having the same amount of shares after the capital injection as before. The percentage of ownership that becomes available -as a result of the founder’s percentage being diluted- is acquired by the Venture capital investors.
On the other hand, in a Company Acquisition, the investors buy some or all of the shares from the shareholder(s). This way, the funds go to the shareholders, not to the company itself, and the total capital of the company remains the same.
In short, in a Company Acquisition, the business does not benefit from the investment unless the investor injects additional funds or helps the business in other forms such as technical or managerial expertise.
2) The second most important difference between Venture Capital and Company Acquisition is that in Venture Capital, the investable companies are small businesses that have yet to reach their potential and generate significant returns on the investment. In a Company Acquisition, however, the investable company is typically an established company with an attractive ROI (Return on Investment) rate.
In short, Venture Capital is typically reserved for long-term investments with no return in the short term but potentially high return in the long term, whereas the investor of a Company Acquisition expects returns in the short term and strives to increase those returns in the long term.
3) Both in Venture Capital and Company Acquisition, some or all of the investment can be non-monetary resources such as marketing platforms, offices, facilities, equipment, and employees. However, due to the nature of Venture Capital and the fact that small businesses need such expertise and platforms more, non-monetary investments are more common in Venture Capital.
4) In Venture Capital, the founder’s expertise and qualifications play a major role in the investment. In fact, it is not uncommon that the founder’s expertise becomes the main reason and the condition for a Venture Capital investment, as the company would be uninvestable without its original founder.
On the other hand, an investment in the form of Company Acquisition relies on the corporate structure (its employees and systems in place) much more heavily than the company’s founder(s). In fact, it is not uncommon that a company’s founder(s) is replaced by the investor’s own team shortly after a Company Acquisition.
Venture Capital as an Investment Instrument
As conclusion, Venture Capital is a well-known investment type and is used by sophisticated investors to diversify their portfolios. However, due-diligence and realistic valuation are vital parts of investing in the form of Venture Capital.
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