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How do venture capitalist (VC) firms work, is the biggest question everyone has. VC's or venture capitalists are a group of investors who provide funds or money or financial support required to small business and startups in terms of investments. In return, they become stakeholders in the company as partners.
One of the major barriers to starting your own business is investment. Any business requires money to get off the ground. You need money to purchase raw material, pay rent, buy furniture and pay your employees.
What are the possible sources of funds for your business?
1. Personal Saving - Some individuals use their personal savings to start up their own business. A major barrier to this technique is that most individuals don’t have enough funds to start up.
2. Reinvestment - In this technique individuals start their business with a very small investment and reinvest the profit they earn. This technique is limited to specific business which can be started with a very small investment. Generally services Company use this technique.
3. Loan - Some business might get a loan from a bank if the banks find them worthy investment. Mostly banks don’t invest in risky businesses making it difficult for entrepreneurs to raise money.
All these sources have their own limitations. Many business do not have access to all these three sources of finance. Another source of finance for business is through venture capital firms.
What are venture capital firms and how do they operate?
A VC firm is a group of investors who raise money from wealthy individuals or organizations who want to grow their wealth. They invest money in small businesses where a bank would generally not invest and earn returns as the business starts growing. In some cases venture capitalist also provide expansion financing to established businesses. This is less common as these business manage to get a bank loan.
Venture capitalists also have managerial and technical expertise. This form of raising money is popular among new ventures with limited operating history, who cannot raise funds by issuing debt. The drawback for entrepreneurs is that venture capitalists usually participate in company decision making process.
Venture capital also bears some risks. It is a risky investment as many new companies fail or underperform. Venture capital firms hedge this risk by investing in multiple companies and hope that their successful investments provide more returns than their losses.
Typically a venture capital firm opens a fund. A fund is pool of money that a Venture capital invests in different firms. The venture capital raises money from wealthy individuals, pension funds, and companies etc. who wish to invest. The venture capital invest the entire fund in different companies and expect to liquidate them in the next few years. Typically 3 to 7 years. The venture capitalist expects the firms in which the invested their money either to go public i.e. sell shares on the stock exchange or get acquired by other firm so that they can liquidate their investment.
Venture capitalists generally work on specific investment profile. The investment profile outlines the types of businesses the firm is willing to invest in. Venture capitalist generally invest in profiles in which they have prior experience or find promising returns. For example, some VCs only invest in technology start-ups. Although this is not necessarily followed by all venture capitalists.
When venture capitalist exit the business it is known as the harvest. It takes place anywhere from 3 to 7 years via an initial public offering or through the sale or merger of the company
Structure of VC firms
The VC firms generally have two key elements
1. General partners
2. Limited partners
The general partners are people responsible of making investment decisions and work with start-ups. The limited partners are people who provide the capital needed for the firms to operate.
Example: Suppose a venture capital raises $100 million from various hedge funds, pension funds and wealthy individuals. The venture capital than invest this $100 million in 10 different companies. Some of these companies will fail. After 5 years, out of the 10 companies in which the VCs invested, some companies get acquired by other companies and some companies go public while a few companies go bankrupt. When VC firms go public or get acquired it is generally millions of dollars. So venture capital firms work on the law of averages, expecting that big returns on some investments overshadow the failures. The VCs now liquidate their fund and manage to raise more than $100 million so that they can pay off their investors with interest and keep a portion of profit for themselves.
This article has been authored by Mudit Jain from SIBM Pune