You may have heard in news about venture capitalists (VCs) investing millions in the next big tech start up without really knowing what’s involved. Our guide gives you the insights into how venture capital actually works and why many growing businesses seek this type of investment.
What is venture capital?
Venture capital is a form funding usually for starts up and small business. The venture capitalists will provide investment for a company in return for a stake (or equity). Venture capitalists hope their injection of funds will help the business grow rapidly and they will be able to make large profits when the business sells.
Due to the nature of start ups, the investment from venture capitalists is seen as a high risk investment. Small business offer the opportunity for high returns, but many will fail despite this significant funding, therefore leaving investors with nothing.
A venture capitalist will spend time evaluating the firm they’re interested in backing, considering whether it’s economically viable. There will be analysis of competitors, the current economic climate and the company’s business plan.
This type of investment tends to be used when the company is looking to grow rather than when they are at a very early stage development - for this reason most deals are worth millions. Venture capitalists will look for concepts which they believe will work and are scalable, but haven’t started making profit as of yet.
Why do start ups will use venture capitalists?
Firstly, they can provide a large injection of cash, whereas other forms of investment may be significantly smaller. They will also be able to provide expertise to assist this growth. Most venture capitalists are specialists in either a specific sector or a part of the business life-cycle.
Venture capitalists are attracted to high growth industry, where the risk is high and so are the returns - tech start ups and apps are an attractive proposition at the moment. These companies wouldn’t be able to get this sort of investment from other sources, but venture capitalists tend to be less risk averse.
How are venture capitalist firms run?
A venture capitalist firm will raise a fund from a number of investors, including institutions and wealthy individuals. Let’s say the fund is worth £100 million. They will then consider opportunities to invest in start ups and spread their fund across a number of companies which they believe are likely to return profits. They may give £1 million to one company, but £15 million to another - it all depends on what they believe the company needs to become successful and their belief about potential returns.
Amongst these companies, some may fail and others will grow quickly and they will be able to sell their share of the business - typically after five to seven years. The aim for the venture capitalist is to make sure the profits outweigh the losses, and they can provide their original investors with a healthy return (after they take a cut).
Is venture capital the way to go?
Venture capitalists are often criticised in the press and they have often been accused of asset stripping to make a quick buck - in other words, they sell off profitable parts of the business to make money, potential as the expense of staff or the business overall. They don’t just give a firm the money and sit back - they are likely to have their say on major business decisions.
However, for many small businesses the combination of a big injection of cash and the expertise offered is exactly what they need. Some companies wouldn’t be able to acquire funds from other channels because they’re viewed as too risky, so venture capital could be one of the few viable options.
Lastminute.com, Apple and Microsoft are just a few of the high profile companies that received venture capital in their early development.