Resources
Resources
Resources
Venture Capitalists
Viewed: 34781 Times

A venture capitalist(VC) is a person who provides equity financing to companies with high growth potential. The money that a venture capitalist invests in a company is called venture capital. Venture capital firms are often limited partnerships that comprise a few venture capitalists. Each venture capital firm manages a venture fund, which is often comprised of a large pool of money--anywhere from $25 million to $1 billion--that the firm invests in growth companies. A venture capital fund consisting of third-party investments can finance enterprises that are too risky for debt financing. Each VC firm invests in several companies and this group of companies is called the firm’s portfolio companies or portfolio.

Most VC firms have different kinds of executives: general partners, limited partners, venture partners and entrepreneurs-in-residence apart from associates and office staff. General partners are the primary investment professionals in a firm. General partners collaboratively manage the firm’s venture fund. Limited partners are the individuals who invest in the venture fund. Venture partners bring in deals and receive income on deals they mark. General partners on the other hand receive income on all deals.

Entrepreneurs in Residence are domain-specific experts who perform due diligence on potential deals. These individuals are temporarily engaged by VC firms for a short period. Typically, they are expected to conceptualize startup ideas or move on to a CEO or CTO role at a portfolio company.

How do VCs generate money?

The primary objective of a venture capitalist is to manage his/her venture fund, provide equity financing to companies that have high growth potential and generate profits from their investments. VCs generate profit by buying a company’s common or preferred stock, helping that company grow and liquidating their own stock once the company reaches a certain size and market value.

A typical venture capitalist invests money in a company by buying equity, thereby becoming its shareholder. Given this situation, if the company fails, the VC is not going to get his or her money back. Since VCs employ equity financing to fund a company, the risk of loss is transferred from the entrepreneur to the VC. An entrepreneur need not return the invested money because VCs own stock and become the entrepreneur’s partners. If the company fails, the value of the VCs’ stock becomes zero.

Although equity finance appears intimidating from an investment point of view, VCs manage the risk by investing in multiple companies that have high growth, thereby creating a portfolio. The logic here is that losses from any failed companies will be offset by the high Return on Investment (ROI) from the successful portfolio companies. In general, if a VC creates a venture fund and invests in ten companies, he or she assumes that five of those companies will fail, three will generate low to average returns, and two will be successful. The VC’s equity in the successful companies generates such high returns that the losses are offset and the entire venture fund increases in value.

How do VCs select companies to invest in?

Given the high risk, VCs rigorously research business ideas before they invest in one. VCs should assess the idea, the business plan, the market dynamics, etc. before investing in a company. The following paragraphs describe the four most important aspects of their decision making.

Companies that target different markets and are at different stages require funding for different reasons. It is virtually impossible to understand the dynamics of every company that needs investment. Therefore, each VC focuses on a type of company and specializes in that particular domain. For example, certain VCs focus only on wireless communications, while others focus only on biotechnology or nanotechnology. Therefore, it is important for an entrepreneur to research the right set of VCs.

Different VCs focus on companies at different stages. Some VCs focus on early-stage companies, where the risk is high, some focus only on expansion-stage companies and others focus only on late-stage companies. Finally, there are other VCs that focus on private equity and leveraged buyouts. In addition, VCs prefer to invest in companies that are within driving distance. They want to drive to their portfolio company and attend monthly board meetings.

VC firms are often considered to be in different levels or tiers. The VC firm’s partners decide whether it is a tier-1 or tier-2 firm. Top-tier venture firms are established firms that generally manage larger venture funds with more money being managed and employ a higher number of experienced VCs who are specialists in their focus areas. Sometimes, top-tier funds are small or second-tier funds have experienced partners, but the above generalization usually fits.

Actions that indicate Top-tier firms:

  • Large initial deals ($5-$20 Million range)
  • Many deals per month (2 to 5) since they have more partners and more money
  • A high percentage of their investments are in later rounds
  • They frequently do merger & acquisition type investments along with pure venture deals

Actions that indicate 2nd-tier firms:

  • Highly-leveraged, smaller initial deals
  • Move faster than top firms
  • At times, they prefer to co-invest in companies along with other Tier-1 VC firms
  • They are more likely to nurture a deal that they feel has promise, although resource limitations can make this difficult for them

It is important to know the dynamics involved in dealing with VCs at different rounds. Startups that raise their first round of capital from 2nd-tier VCs often have trouble finding top-tier VCs in later rounds. Top-tier VCs prefer to retain the managing control of a startup, which might be difficult if the first round of capital was raised from smaller 2nd-tier investors.

Dealing with Top-tier VCs often results in spending a large amount of time and money negotiating terms with lawyers. 2nd-tier firms, on the other hand, move very quickly to close the deal at hand.

VCs not only invest in companies, but also help companies succeed. They advise the entrepreneurs and assist with customer contacts, market specific intelligence, etc. A VC is successful only if his or her portfolio companies succeed.

Of course, VCs are also human beings with their own share of mistakes. Some VCs make irrational decisions and do not treat portfolio companies fairly. Some become greedy and deprive the founders and employees of returns. There are horror stories all over the internet. Therefore, entrepreneurs should research the backgrounds of the venture firms they deal with.

This article is intended to provide a brief overview about venture capitalists and venture capital firms. You may want to explore other avenues using a Google search to gain a thorough understanding of the concepts and workings of a venture capital firm or a venture capitalist.

Written By
Pradeep Tumati (Principal, go4funding.com)

 Digg It    Stumble It    Deli.icio.us

Related Articles