In general terms, venture capital is equity financing provided by investors to private, early-stage companies pursuing new business models, markets, science or technologies, which companies have significant growth prospects and the potential to provide the investors with exceptional long-term returns.
Elements of Venture Capital
- Equity financing. These investments are typically for stock in the company or for securities that convert into or are exchanged for stock in the future.
- Preferred stock. While founders obtain common stock in the company, venture investors generally invest in preferred stock of the company. This preferred stock provides the investors with certain rights, preferences, protections and privileges that are often in are superior to these of the common stock holders.
- Bank debt. Most traditional banks don’t loan money to early-stage companies, as these companies don’t have sufficient revenue (or any revenue) or assets to provide the basis for a bank loan. Another type of investing, known as buyouts, uses both equity and debt to finance a transaction. In buyouts, the companies generally have sufficient cash flows and assets to provide the basis for the loans.
- Convertible securities. Often companies will issue short-term debt to investors as a simple, economical way to obtain interim funding until the preferred stock round of financing is raised and closed. This debt, known as convertible debt, converts into the preferred stock issued in the financing round. There are also other types of instruments that have been introduced, which serve as a “bridge financing” until the company raises a larger venture capital round of financing.
- Non-control investment. A venture capital financing is typically for less than a majority of the stock of the company, which means that the venture capital investors don’t have absolute control over the company. The founders and other common stockholders will typically own a majority of the outstanding stock, and appoint a majority of the members of the board of directors and also have voting control in many situations. Having said that, a key aspect of venture capital financings is the issuance of preferred stock, which enjoys certain rights, preferences, protections and privileges that provide the investors with certain elements of control.
- Privately-held companies. The companies receiving venture capital financing are private companies, meaning that their stock is not traded on a stock exchange and so is known as restricted stock for the restrictions on the ability to sell or transfer the stock. Stock exchanges provide a mechanism for people to efficiently trade shares of public stock, and this stock is called “liquid” for the ease and speed of trading the stock. Conversely, restricted stock such as preferred stock issued in venture capital financings is known as “illiquid” because of the restrictions on the ability to sell the shares.
- Initial public offering. If an early-stage, venture capital-backed company is very successful and grows its revenues and cash flow, the company may become a candidate for an initial public offering, or IPO. An IPO establishes a public market for the companies, by registering securities with the Securities and Exchange Commission (SEC) and listing the stock on a public stock exchange such as NASDAQ or the New York Stock Exchange (NYSE). After a period of time (usually six months after the IPO), the restrictions on transfer expire and venture capital investors can start to sell their holdings in the company on the public market.
- Early-stage companies with high growth potential. Early-stage companies are companies that are very early in their business development cycle. These companies are often pre-revenue, developing their software, service or product, and are often pursuing new business models, markets, science or technologies. Investors must be convinced that this company has high growth potential - think Uber and AirBnB.
- Late-stage venture investing. Late-stage venture investing refers to investing in a company that has had previous venture capital financing rounds, and the company has become a leader in their industry or sector. From the investor’s perspective, the investment risk is lower as the company has established that the market exists and that the market has accepted the company’s product. Late-stage
- Growth investing. There’s a type of investing known as “growth” investing or “venture growth” investing. This type of investment is made in private companies that have developed to the point that their service or product has been accepted by the market, the company has a solid revenue base and the company needs capital to ramp up the growth of the company. Often these companies have had no external equity financing to this date, and growth investors help the companies reach the next level of development.
- High risk investments with high potential return on investment. From a venture capital investor’s perspective, investing in an early-stage company has significant risk, but also has the potential to deliver a massive return on the invested capital. Early-stage venture capital investors are not investing in order to get twice their money back on a given investment – the expectation is much higher. Why? Because a significant portion of early-stage investments don’t perform well – either returning a loss of investment or a very modest gain. Because of this, venture capital investors invest in a portfolio of companies to mitigate the risk of loss of an individual investment.
- Long-term investments. Another consideration for both founders and venture capital investors is that in an investment in an early-stage company is a long-term commitment – the time from initial investment to when the company is sold or the company holds its IPO can be a long, long time. Based on my experience, early stage investments can take 5 to 7 years on average to exit, but it is not uncommon for investments to last 10 to 12 years or longer before the investor can “exit” the investment. I am working with a couple of funds right now that have investments that are over 15 years old.
- Investors. Who are these investors? The investors may be high net worth individuals (also known as “angels”), groups of angels (angel networks), venture capital funds (investment funds established by venture capital firms), funds-of-funds (funds created mainly to invest in venture capital funds, but also may invest directly in early-stage companies along-side their portfolio venture funds), venture divisions of corporations (called “corporate venture capital”), foundations, endowments, and increasingly mutual funds and hedge funds, among others.
So this is my introduction to venture capital. Please let me know if you have any suggestions on how this might be improved.