What is a “venture capital”?

June 23, 2021

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3 min read

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Origins

The roots of venture capital date back to the times of Christopher Columbus, when states would spend vast amounts on funding voyages in the hopes that explorers might make extraordinary discoveries. From high-risk investments and high-risk entrepreneurs, venture capital itself evolved at the end of the Second World War to encourage private sector investment in businesses run by returning soldiers. The very first venture capital firm was the American Research and Development Corporation founded in 1946 by Harvard Business School professor, George Doriot. He is known as “the father figure of venture capital”.

Doriot’s firm saw its first major success story in its investment into the Digital Equipment Corporation, which changed the course of computer technology. The investment of $6m yielded a $400m return, and the financial opportunities of venture capitalism became known worldwide.

The dot com boom also brought the industry into sharp focus, as venture capitalists seized opportunities to go after quick returns from highly-valued Internet companies. 

Today, whether you are catching an Uber, or booking an Airbnb, you are using services and products from venture capital-backed companies each day.

Overview

Even though the industry is constantly changing, the fundamentals of venture capital have remained the same: 

Venture capital is essentially when investors provide funds to start-up companies and small businesses that are believed to have long-term growth potential. 

The financing which is deployed by a venture capital firm usually comes from institutional investors, corporations, or wealthy individuals often referred to as ‘angel investors’.

This venture capital investor may spot the potential for long-term growth in a company, and initiate the due diligence process. This includes a thorough investigation into the company’s business model, its products, management, and operating history. This is to ensure that the investor is really getting what they have been advertised!

As companies grow, they go through different stages of venture capital. The stage of development at which a company may find itself will impact how a venture capitalist will invest. Investment may feed into companies through “seed funding” at the earliest stage of its development, or at a later stage when a company has begun to make considerable revenue in select markets and is looking to expand its operations.

So who wins? – well, both – if the company is successful, the company will grow, and the investor will benefit from a return on investment. Many investors expect a return of between 25% and 35% per year over the lifetime of the investment.

Verdict

Venture capital is high-risk but potentially a high-reward game. Venture capitalists will be aware that not every company in their portfolio will produce a huge return on investment, therefore it is wise for them to invest in companies which, after a rigorous due diligence process and getting to know the business, appear to have excellent odds of being successful.

Besides the investment itself, another big advantage of venture capital for a small business is that they often receive support from the venture capitalists who might have skills relevant to their business. More experienced in the world of boardroom politics, and often with a large array of useful connections, these investors can offer more than money, namely mentorship, lots of experience and possibly even technical expertise. However, this can lead to a conflict between venture capitalists and start-up founders who exert too much influence over the company. Too much ‘top-down’ control can occur where contracts are not properly scrutinised, and can end up with some very angry founders.

The lawyer’s role in all this is particularly important. Every founder’s greatest fear is losing their business. Promising start-ups not only face this threat from larger corporations who might want to poach their employees, but also from greedy venture capitalists. Therefore, the start-up’s articles of association, which define responsibilities and shareholder structures, can greatly impact who is really in charge of a company, whilst the contracts for board members and employees should be drafted with these concerns in mind. 

Hopefully after a healthy return on investment, the investor will exit the company. This happens typically four to six years after the initial investment. As they do so, they will often initiate a merger, acquisition, or initial public offering which makes the company public on the stock market, ready for its stocks to be grabbed up!

Report written by Hannah Parker

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