Venture capital, often referred to as VC in the finance realm, is the money provided to early-stage growth companies in return for an equity stake in the business.
Venture capital falls into the broader reaching domain of Private Equity (PE) which can trace its origins to the private financing of the Transcontinental Railroad in 1854. However, the more modern origins of private equity date to the late 1940s and 1950s, with the first commonly acknowledged venture-financed business, Fairchild Semiconductor, receiving finance in 1957.
Since then venture capital has gone through many periods of boom and bust, the first dot-com bubble bursting in 2000, and has ultimately grown into a $48 billion industry as of 2014.
How does venture capital work?
Venture capital firms raise funds of money from private investors with the expectation that the fund will return investors more than they invested. The investors in the firm are referred to as general partners (the actual partners of the firm who will typically invest 1% of the fund) and limited partners (typically pension funds, endowments of universities and hospitals, charitable foundations, insurance companies, very wealthy families aka family offices, and corporations). Occasionally a high-net-worth individual will be a limited partner.
Once the fund has been raised, the partners in the firm will go on to make a number of investments in high-growth early-stage companies in return for an equity stake in the business. In addition to the investment, the venture firm will often provide guidance, mentoring, network connections and a plethora of other benefits.
The types and stages of companies that the fund will invest in are often outlined in the fund’s Information Memorandum. Often the fund will set aside a portion of their funds to be used in follow-on rounds.
Ultimately the fund looks to exit the companies they have invested in either via a trade sale or though the IPO of the company. Venture funds tend to work on a cycle of seven to ten years, raising finance and aiming to exit their investments in the expected period, and pay the profit out to the general partners and limited partners before that period ends.
Of note, in the UK there are special types of venture capital trusts or funds that allow investors to receive tax reliefs from the government. These are SEIS funds and EIS funds.
How can an investor invest in a venture capital fund?
Individual investors are often excluded from investing in larger funds as the minimum investment level may be quite high ($1,000,000-plus). Smaller funds will likely accept smaller minimum investments, with some funds having minimum investments in the low thousands, thus opening the door for individuals to get involved.
What sort of returns should an investor expect from a venture capital fund?
The Harvard Business Review reports that since 1997, venture capital as an industry has returned less cash to investors than what was invested. Further, of 100 funds surveyed, 62 did not beat the returns that would have been received had the investor put money into the public markets. However, 20 of the firms returned higher than what would have been returned from the market while a small number returned significant amounts to investors.
Venture capital is considered risky, and yet, the potential for incredible returns is alluring. Those who wish to invest in venture should do their homework on what the fund will invest in, how it will invest in it and who will ultimately be making the investment decisions. Bigger is not always better, and a track record does not always mean the next fund will return the same.
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