One of the most important sources of funding for startups with limited operating history that do not have access to capital markets is Venture Capital (“VC”). Venture capitalists own an equity stake in the start-up and have a say in the functioning of the company. Investments are generally made in early stages of a company with long term high growth potential. Most venture capital comes from groups of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships.

How Do Venture Capitalists Generate Revenue?

Venture capitalists become part owners of the companies they invest in and therefore are entitled to returns as are any other equity holders in the company. However, because the majority of portfolio companies are in a relatively early stage of development and far from being able to issue dividends, they usually keep and reinvest any profits.

Consequently, the main source of revenue for a venture capital fund comes from exiting the investment at the end of the investment horizon. The various exit options include an initial public offering, a trade sale or selling the business to another investor. Trade sales are mergers or acquisition transactions with another company in the same industry or a conglomerate intending to diversify, whereas VCs usually sell businesses to other venture capital funds, private equity firms or high-net-worth individuals.

In order to achieve the desired returns at the time of exit, venture capitalists need to sell their stake at a higher price than that at which they made the initial investment. The negotiation in terms of sale price at exit in trade sales or selling to another investor is primarily based on the valuation of the company's portfolio. The venture capital funds therefore focus on increasing the value of the company over the period of their investment. They help the portfolio company to break even by lending their managerial and technical expertise so that it can generate higher and stable cash flows, and achieve substantial market share. (For more see Cashing In On the Venture Capital Cycle.)

Getting exposure in venture capital funds

Venture capital funds typically raise funds through private placements. Investors are usually very high-net-worth individuals capable to take liquidity risk or any other risk part of the private placement. Most often the funds are pooled in the form of partnerships where the VC acts as the general partner and private investors act as limited partners. Some funds are organized as limited liabilities companies. General partners (commonly known as venture capitalists) have control of the fund and are managers and investment advisors to the fund.

Once the the portfolio company is selected, VCs call down the funds from limited partners. Limited partners who have made a capital commitment but fail to provide the funds when called can suffer penalties. The cost charged by the VC is in the form of management fees (often 2%) and performance fee (often 20%) which is a percentage of profits retained by the general partners. The rest is distributed to the limited partners, i.e. the investors.

Evaluating Funds for Investment

The basic parameters investors can use to analyze VC funds include:

1) Target Industry

Venture capital funds generally specialize in investing in a particular industry or a specific type of company. While most of them invest in high-growth companies, some might choose investments only in technology related ventures, telecommunication or bio-technology startups. Industry specialization is beneficial because of acquired experience and expertise. Also, the network they develop in an industry-specific ecosystem often results in more value for the portfolio company. (For more, see: How Venture Capitalists make Investment Choices.)

2) Principals and Venture Partners

Portfolio companies add value through the efforts of the principals and the VC team members. They are the individuals who drive the operations and strategy in the portfolio company to achieve a higher valuation. An investor needs to evaluate not only the resumes, prior investment performance records, and industry specialization of the principals but also the credentials of the venture partners (general partners who manage the investment).

Other factors to include in an investor's analysis include the minimum investment amount required by the fund, the firm’s strategy, risk factors, the potential deal pipeline and so forth.

The Bottom Line:

Venture capital funding is characterized by high risk and high returns. New products or ideas normally have a high level of uncertainty, and most of them only become profitable after a few (or many) years of losses. High-growth industries are very susceptible to fast changes. VCs, however, represent a disproportionately large opportunity for making returns if the investment is successful. Thorough research is critical to make sure the investor's and the firms investment objectives and risk appetite are aligned and common goals have been set. 

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