Venture capital firms specialize in providing equity financing for firms that are in an early stage of development (start-ups).
Examples of companies that received venture capital funding in their early development include Apple, Federal Express, Microsoft, Genentech, and Google.
Venture capital (a.k.a. private equity) is a pool of capital most commonly organized as a limited partnership. The venture capital firm serves as the general partner and investors are the limited partners. Limited partners can include pension funds, university endowment funds, wealthy individuals, and other financial institutions and corporations.
Managers of venture capital firms (venture capitalists) closely follow the technology and market developments in their area of expertise (e.g., computer software, communications, computer hardware, medical/health, industrial/energy, biotechnology, retailing, restaurants, etc.)
They screen entrepreneurs and their business concepts prior to making an investment. To diversify risk, they create a venture fund that is a portfolio of investments in young companies.
Venture capitalists are not passive equity investors. They structure a financing deal with great attention to creating the right incentives and compensation for the start-up firm’s owners. They are also instrumental in raising additional financing during future stages of the firm’s lifecycle.
A venture capital firm typically raises money for a venture capital fund by obtaining commitments from limited partner investors. Based on the fund’s prospectus, limited partners agree to make investments for a period that is often 10 years.
After commitments are obtain, the VC begins making investments in young companies. VCs make “capital calls” to the limited partners as funds are dispersed to the start-up companies.
The most common way that the VC obtains a return from its investment in a start-up company is by the company being acquired by a mature corporation. In other cases, the VC obtains a return when the company issues an IPO. After the IPO, the stock held by the VC is given to the partners who can continue to hold it or liquidate it.
VC financing grew tremendously during the 1990s. The recession and decline in technology firms (a major source of VC investment), led VCs to reduce their investments because prospects for making profits in start-ups was greatly reduced.
While it may be some time before VC activity returns to the level of the “bubble” years of 1999-2000, VC financing will remain an important source of funding for entrepreneurs with innovative business strategies.