When many people hear the term, “Venture Capital”, they have no idea what it means. The term can be confusing. The everyday employee has no reason to interact with a VC and quite frankly, it is the financial jargon can be intimidating to even the seasoned financial analyst.
That is why an introduction to venture capital is in order. The U.S Small Business Administration gives a good explanation of what this field of expertise and finance is all about. The SBA defines Venture Capital as
“A type of equity financing that addresses the funding needs of entrepreneurial companies that for reasons of size, assets, and stage of development cannot seek capital from more traditional sources, such as public markets and banks. Venture capital investments are generally made as cash in exchange for shares and an active role in the invested company.”
By a very generic definition, Venture Capitalists serve as investors to start up companies. By analyzing the variables that each company carries, they make decisions about investing and whether or not they will see a return on their investment. The SBA shares some of those variables in the same article:
Venture capital differs from traditional financing sources in that venture capital typically:
- Focuses on young, high-growth companies
- Invests equity capital, rather than debt
- Takes higher risks in exchange for potential higher returns
- Has a longer investment horizon than traditional financing
- Actively monitors portfolio companies via board participation, strategic marketing, governance, and capital structure
One of the other things that is crucial to understand is the difference between a VC ( Venture Capitalist) and an Angel Investor. The major difference is that VC’s often work for or run firms and Angels are private investors who are typically retired entrepreneurs or VCs. John Greathous, contributor to Forbes online does a good job of making this distinction clear and accessible in an article entitled “Pssst…Here’s How To Become A Venture Capitalist”:
There are many paths into the VC world, but they can generally be lumped into two categories: (i) serial entrepreneurship, and (ii) tech-oriented investment banking. I define a “VC” as, “a professional investor who deploys third-party funds into relatively early-stage companies.” In contrast, an Angel Investor IVSBY +% is someone who invests their own capital. All you need do to become an Angel is identify a promising venture and write a check.
The last thing to be educated on is a clear definition of equity capital. When companies raise money to fund their businesses, they often exchange stock in their company for money or capital. The sources for these funds are angel investors and venture capitalists. Again, the SBA does a good job of explaining this.
Equity capital or financing is money raised by a business in exchange for a share of ownership in the company. Ownership is represented by owning shares of stock outright or having the right to convert other financial instruments into stock of that private company. Two key sources of equity capital for new and emerging businesses are angel investors and venture capital firms.
Typically, angel capital and venture capital investors provide capital unsecured by assets to young, private companies with the potential for rapid growth. Such investing covers most industries and is appropriate for businesses through the range of developmental stages. Investing in new or very early companies inherently carries a high degree of risk. But venture capital is long term or “patient capital” that allows companies the time to mature into profitable organizations.
Angel and venture capital is also an active rather than passive form of financing. These investors seek to add value, in addition to capital, to the companies in which they invest in an effort to help them grow and achieve a greater return on the investment. This requires active involvement and almost all venture capitalists will, at a minimum, want a seat on the board of directors.
Although investors are committed to a company for the long haul, that does not mean indefinitely. The primary objective of equity investors is to achieve a superior rate of return through the eventual and timely disposal of investments. A good investor will be considering potential exit strategies from the time the investment is first presented and investigated.
Hopefully, these distinctions and definitions are helpful in making the language and nature of venture capital more accessible to the general public. The goal will be to continue this conversation by demystifying and clarifying the nature of this business.
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