The Executive Suite: How Does Venture Capital Work?

Friday, May 31, 2013

How Does Venture Capital Work?

Investors and entrepreneurs often share the same goal: to make lots of money. Not surprisingly, since each has what the other lacks, a vibrant market for venture capital has evolved to bring together those starting a business with those looking for places to invest cash. The ideal candidates for venture capital investment are businesses that are too small or immature to obtain bank financing, or to float debt in public bond markets, yet whose start-up costs are too large to rely on private savings. Businesses steeped in biotechnology or communications, for example, often have high barriers to entry, and require the huge sums that only venture capitalists are willing to provide. But most venture capitalists are not individuals exactly, but a sort of business unto themselves. In most cases, many individual contributors pool money in a large fund and hire a select management team to makes decisions on spending the money.

Some put their money in stocks or bonds, in mutual funds or commodities, but the bravest and most discerning investors put their money behind unproven business ideas, and work hand in hand with entrepreneurs to help them flourish. For the venture capitalist, the entrepreneur is an investment. In exchange for their cash, they receives a large number of shares in the fledgling company and, most likely, some influence on management and executive-level decisions. For the business owner, the venture capitalist is a lifeline, a means to getting an idea off the ground. By selling a stake in future profits, they're able to hit the ground running in the present. When everything falls into place, the arrangement between the two is mutually beneficial, and very profitable.

While some entrepreneurs may be satisfied simply by seeing their ideas to fruition, most have a profit motive. The venture capitalist, of course, is entirely driven by the potential for return on capital and needs profits to stay in business. In fact, the shares of the company the venture capitalist originally receives are essentially worthless at first. But the goal is to steer the fledgling business towards an acquirer or towards the public stock markets. By building prototypes, gaining clients, and successfully conducting business, the team of entrepreneur and venture capitalist add value to the business with the hope that, in three to five years from the outset, the once risky start-up will have blossomed into a more stable enterprise worth substantially more than the original start-up and operating costs. Whether the business is absorbed into a larger conglomerate in a related field, or the company goes public for hundreds of millions of dollars in the stock market, the venture capitalist stands to make tens or hundreds of times the original investment. The entire gambit is significantly risky, of course, and venture capitalists rarely put all their money into a single business, even though they tend to invest all their available cash. By spreading the wealth amongst several different start-ups, the venture capitalists plays the odds knowing that just one or two successes will more than recoup the losses of the others.