Venture Capital

Venture capital is a type of financing used by small and medium-sized businesses. Because these companies are early in their development cycle, they are riskier investments, leaving them unable to get traditional financing from banks. Although venture capital is a relatively small fraction of global corporate investments, it has contributed to an amazing amount of economic growth, facilitating the emergence of companies such as Microsoft, Google, and Yahoo. Venture capital is usually invested in return for equity (shares) in the company rather than fixed debt, as to account for the greater risk these investments represent. Venture capital is usually invested with a three-to-seven-year perspective. Failure rates can vary anywhere from 20 to 90 percent of the portfolio, and expected returns are between 30 to 100 percent (to offset for failures within the portfolio).

Venture capital has the advantage of being available for risky and new businesses as well as providing access to venture capitalists, who are usually industry experts able to supply valuable insight to the companies they invest in. Nonetheless, obtaining venture capital implies a certain loss of control in management decisions, and can be quite costly in terms of administrative costs and time. Venture capital fills an important gap in the financing cycle, enabling the growth of high-risk companies.

There are five main types of venture capital adapted to different companies. A smaller venture capital investment is called seed capital, and is used by companies to create a prototype and fund basic market research. Start-up capital is used to fund recruitment of key management as well as finalizing the product for commercialization. Early stage capital is used to increase productivity and increase company efficiency, while expansion capital is used to enter new [Page 1678]markets. The last stage of venture capital, late stage capital, is used to increase capacity and marketing, while preparing for the exit of the venture capital.

Venture capital can be obtained through two different processes. Some companies will negotiate milestone-type financing, where the next amount of financing will be made available once it reaches predetermined goals. For example, a company could link milestones to sales: once a sales target is reached, the venture capital would be released. The advantage is that the company can raise great amounts of capital upfront, leaving less pressure in the future to secure more funding. Other companies prefer seeking venture capital in the form of financing rounds, entering a new financing round after certain internal goals are met. In these cases, venture capital firms who have already invested in these companies usually require a right of first say, so they can be the first company to evaluate the potential investment and decide if they want to invest in the next round. The advantage is that financing terms are advantageous when negotiated as the company progresses. As the product is more successful, there is less risk for the investor, and the company can divest less equity, or give up less control than if it had negotiated the financing up front.

The venture capital investment usually takes the form of equity in ordinary shares, but can take many other forms. Financing is usually based on company effort, venture capitalist effort, venture capitalist preference, and feasibility of the underlying technology. The three main structures of venture capital investments are ordinary shares, preferred shares, and debt. Ordinary shares are cheaper for the company to finance in the short term, and profit expectations can be quite elevated for the investor, but usually imply a loss of control for the company (due to the emission of voting shares). Preferred shares have priority over ordinary shares in case of bankruptcy and usually have fixed dividends, but do not always carry a voting right. Finally, debt is usually secured against existing assets, and requires fixed repayment; this is also called venture debt.

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