Venture capital is a form of financing provided by specialized firms to startup companies and small businesses. While a financial investment is involved in virtually every venture capital deal, many deals also include advisory services provided by the venture capital firm to the company that they are investing in.
Venture Capital Investment Theory
Venture capital firms take on a large degree of risk by investing in companies that are still in their infancy in the hopes that their initial investment will be repaid many times over by the enormous potential for growth that small companies with a successful idea represent.
It is commonly accepted that if more than 10% of a venture capital firm’s investments succeed, then they are not taking on enough risk. This adage suggests that firms are more interested in finding the rare small number of firms that will be incredibly successful than a larger number of firms that are more likely to be successful yet to a much lesser degree.
Venture Capital in Portfolio Theory
Venture capital investments are often a feature of large and advanced investment portfolios, whether as direct investments by an internal team or as an indirect investment in an outside firm.
Venture capital investments offer a rate of return that is generally above the rate of return of most equity benchmarks. However, venture capital investments also tend to have riskier and more variable rates of return compared to these same equity benchmarks.
Many investment professionals are also attracted to investments because they offer a rate of return that is not tied directly to the performance of other assets. While venture capital returns do tend to go down during general economic and market downturns, the correlation is not as strong as that witnessed between other asset classes.
Angel investors can be considered a subsection of venture capital firms that focus on companies and entrepreneurs who are in the earliest stages of developing a company, product or even idea. Angel investors are often entrepreneurs from the same industry area, and much of the expertise that they offer is based on their passion for the industry and for entrepreneurship in general.
While VC investments are usually focused on the advanced stages of product development or marketing, for example, angel investments may be much smaller sums that allow the entrepreneurs to lease office space and focus more of their time on their development process.
Venture Capital Investment Process
The financing and professional guidance provided by venture capital firms tend to be in such high demand that prospective investments come to them, instead of venture capital firms actively seeking out small companies to invest in. Therefore, most venture capital investment processes start with the evaluation of submitted business plans for attractive prospective investments.
After a potential investment is identified, a VC firm performs a due diligence process to verify that the information provided is accurate and representative. Then the firm will conduct one or more interviews with the principals of the prospective investment to gauge for professionalism, competency, drive and a reasonable cultural fit with the venture capital firm.
Companies that are selected will then receive their financing in stages as certain specific development landmarks are met. The venture capital firm will generally also offer guidance and support in the form of advice, contacts and direct involvement in the development process.
As development milestones are achieved, the venture capital firm will continue to disburse funds according to the agreement, and may be involved in further rounds of funding, both internally and through seeking out new investment partners, which may or may not be other venture capital firms.
VC firms may retain their stake until a company goes public in an initial public offering (IPO) or until a traditional private buyer is found, or they may sell their stake at some intermediary point before the company is fully-formed.
Traders will rarely have a reason to deal with venture capital firms or the venture capital investment process. However, IPOs represent a number of excellent opportunities for trading, so traders who cover IPOs are often knowledgeable about major venture capital firms and the fates of the companies that they have brought to market in the past.