Venture Capital Explained

Venture capital is an important funding source for start-ups and other companies with a limited operating history and doesn’t have access to capital markets.

Venture capital (VC) is associated with some of the economy’s most innovative and high-growth companies. Scores of startups commercializing transformational technologies have been backed by VC. A VC firm typically looks for new and small businesses with a perceived long-term growth potential that will result in a large payout for investors. For startup entrepreneurs without a fortune to spend on a business venture, VC enables them to test out their business idea on the market, helping make our world a bit more of an equal opportunity society. 

 

 Definition of Venture Capital 

Several scholars have defined VC differently. According to Kortum and Lerner, VC is “equity or equity-linked investments in young, privately held companies.”

Balboa and Marti define VC as “the professionalized financial activity consisting of investing in companies which are in the start-up or expanding stages.” This definition is consistent with the definitions of Megginson, Da Rin, Aizenman, and Kendal” “Venture capital is a type of financial intermediary that is specialized in the entrepreneurial financing companies.” Gilson and Black define VC consistent with American understanding as “investment by specialized organizations VC funds in high growth, high risk, often high-technology firms that need equity capital to finance product development or growth.” 

A VC is a private equity investor that provides capital to companies with high growth potential in exchange for an equity stake. VC falls under the private equity asset class. VC funds frequently make corresponding investments. These funds aggregate capital from numerous different investors and invest it in newly founded companies with solid growth potential. Parties that invest in VC funds include institutional investors like banks and insurance companies, operative companies, government funding agencies such as the KFW, and wealthy private individuals. Given the uncertainty over the success of growth companies and the high failure rate among startups, VC investments are always a relatively high risk – hence the standard synonym for VC, ‘risk capital.’ At the same time, the money gives young companies new chances for development and growth, which is why it is also known in some cultures as ‘opportunity capital.’ 

In the United States, VC comprises three types of investing: seed, start-up, and expansion investment. Metrick and Yasuda conclude that VC is a form of private equity, an asset that cannot be traded in public markets. EVCA and Jeng and Wells share this view. EVCA adds that VC focuses on innovative firms in the early (seed and start-up) and expansion stages of their existence. 

What venture capitalists bring to the table is not just their capital but their knowledge and expertise when starting a business. They are in a position to advise the founders on strategic aspects of their nascent company, such as the best structure for the organization or how to develop new markets. They can also give founders the benefit of their experience and networking skills to help them build distribution networks and acquire cooperation partners.

Venture capitalists take a considerable risk when they invest in a company that is not yet turning a profit. To ensure that the risk translates into an appropriate return, VC investors must carefully select which companies to finance. It is in their interests to select the startups with the highest potential, therefore, ensuring the efficient allocation of resources: VC flows into startups with the best prospects for growth, given limited access to resources. As such, VC drives the productivity and competitiveness of the economy as a whole. 

Studies have shown that VC-funded companies grow much faster than comparable firms – and not just in revenues and profits, but in the number of jobs they create, too. Moreover, VC principally goes into companies with digital and research-intensive business models. So risk capital is being used to fund innovation and new market development. According to a study by Stanford University, 17 percent of all listed companies in the United States were financed by VC in the seed stage. What these companies spend on research and development makes up 44 percent of the total R&D spending of all listed companies in the US.

 

 

Photo: Alfa Photo/Shutterstock

 


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