Venture Capital Firms
Suppose you develop and market a new process that you think has a great chance of being a success. However, since it is new and unproven, you cannot get funding from conventional sources. Commercial banks will not loan you money, since there's no established cash flow to use to repay the loan. It will be hard to sell stock to the public through investment bankers because the company is so new and has not yet proven that it can be successful. In the absence of alternative sources of funds, your great idea may not have a true chance to be developed. Venture Capital firms provide the funds a start-up company needs to get established.
Venture capital firms can alleviate the information gap and allow firms to obtain financing they could not obtain elsewhere. First, as opposed to bank loans or bond financing, venture capital firms hold an equity interest in the firm. The firms are usually privately held, so the stock does not trade publicly. Equity interests in privately held firms are very illiquid. As a result, venture capital investment horizons are long-term. The partners do not expect to earn any return for a number of years, sometimes a decade.
As a second method of addressing the asymmetric information problem, venture capital usually comes with strings attached, the most noteworthy being that the partners in a venture capital firm take seats on the board of directors of the financed firm. Venture capital firms are not passive investors. They actively attempt to add value to the firm through advice, assistance, and business contacts. Venture capitalists may bring together two firms that can complement each other's activities. Venture capital firms will apply their expertise to help the firm solve various financing and growth-related problems.
The process of the investment
A venture firm begins by soliciting commitments of capital from investors. These investors are typically pension funds, corporations and wealthy individuals. Venture capital firms usually have a portfolio target amount that they attempt to raise. The average venture fund will have from just a few investors up to 100 limited partners. Because the minimum commitment is usually so high, venture capital funding is generally out of reach of most average individual investors. The limited partners understand that investments in venture funds are long-term. It may be several years before the first investment starts to pay. So, the illiquidity of the investment must be carefully considered by the potential investor.
Once commitments have been received, the venture fund can begin the investment phase. Venture funds either may specialize in one or two industry segments or may generalize, looking at all available opportunities. It is not uncommon for venture funds to focus investments in a limited geographic area to make it easier to review and monitor the firms' activities. Frequently, venture capitalists invest in a firm before it has a real product or is even clearly organized as a company; this is called seed investing. Investing in a firm that is a little further along in its life cycle is known as early-stage investing. Finally, some funds focus on later-stage investing by providing funds to help the company grow to a critical mass to attract public financing.
The goal of a venture capital investment is to help nurture a firm until it can be funded with alternative capital. Venture firms hope that an exit can be made in no more than 7 to 8 years. Later-stage investments may take only a few years. Once an exit is made, the patners receive their share of the profits and the fund is dissolved. A venture fund can successfully exit an investment in a number of ways. The most glamourous and visible is through an initial public offering. While not as visible, an equally common type of successful exit for venture investments is through mergers and acquisitions. In these cases, the venture firm receives stock or cash from the acquiring company. These proceeds are then distributed to the limited partners.