Venture capital (VC) managers aim to invest in startup companies that are early in the development stage - often pre-profit - with high growth potential. They invest far smaller amounts than buyout or growth funds, but generally hold a larger portfolio of companies.
Venture capital in a nutshell
Venture capital funds look to finance early-stage companies that have high long-term growth potential that seek to develop and establish their business models. Funds will often specialise in a particular sector or region, to better assess investment opportunities in the space.
Given the lack of cash flow for most early-stage target companies, investment valuation is not as simple as for buyout or growth funds. This - along with the lack of a track record to guide future performance estimates - means that the risk involved in Venture capital investing is far higher than later-stage investing. To diversify away this risk, Venture capital funds generally make a large number of small investments. That way, even if most investments in the portfolio fail, the incredible success of a few will more than make up for them in overall return.
Although acquiring minority stakes, VC’s have an active involvement in the portfolio companies. VC managers often implement protective covenants for their investors such as asking for board representation, equity options and tag-along clauses.
Venture capital firms typically aim to exit investments by way of an IPO - if the company is mature enough - or a strategic M&A transaction where the company is incorporated into a large industry player. For example, a manager may guide a mature, customer-facing tech company toward IPO, while it may make more sense for a B2B service company offering specific functionality to be bought out by a larger tech firm that can benefit from owning the technology.
Sector and geography focus: Venture capital managers generally hold deep expertise in a specific sector or geography, allowing them to better identify, source and build successful businesses. For example, a firm might invest only in B2B software in North America or healthcare in Western Europe.
Investor confidence: When an early-stage company receives investment from a trusted Venture capital firm, it adds credibility - both to other industry stakeholders and future investors.
Shared experience: Many Venture capital firms are run by former founders of successful startups, who put their industry experience and personal network in the hands of new founders.
Establishing strong management: Venture capital managers will guide companies through building successful management teams as the business develops, often utilising their relationships within a sector or region to find the best talent.
Exit planning: Like buyout and growth equity firms, Venture capital managers will leverage their network to prepare for the best exit avenue. If a company is ready for an IPO, the manager will guide them through the process or - if they are not ready - sell the stake to a later fund to retain ownership within the firm. Another common strategy is to lead the company through an M&A transaction to a strategic buyer (see How does private equity work? more on each of these exit strategies).
The Stages of Venture Capital Investing
Venture capital firms invest across financing stages, either focusing on one stage or reinvesting throughout, depending on their strategy:
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