Venture Capital Funds – What Are They?
Venture capital funds can be defined as monetary assistance given to a new and unquoted company in its early stages of development. Venture capital funds provide businesses with finance for resources – recruitment of business talent and manual labour, incorporation of state-of-the-art machinery and advanced technologies, and so on. Venture capital funds are high-risk business investments, primarily dependant on strong business plans and innovative product ideas of the invested companies and the profits they generate.
Venture capital funds are raised by venture capital firms that are organised as limited partnerships or limited liability partnerships. Partnerships comprise of limited partners who contribute 99% of the capital, and general partners who contribute 1% of the capital. Venture capitalists are interested in reaping profits on investments. This often prompts them to assume entrepreneurial roles and actively participate in the invested company’s management and production areas. Any gain on capital investments is returned in the same percentage as contributed by partners of the venture capital firms.
The 4 Stages of Development of Venture Capital Funds
Professionally managed venture capital funds usually last for 10 years and passes through 4 stages of development that include providing seed investments, start-up, management and expansion finance, and leveraged buyout financing.
Fundraising: The limited partners of a venture capital firm consist of investors like corporate pension funds, personal investors and private and public endowments that help raise venture capital funds. The general partners are required to obtain commitments from the limited partners towards the capital raised. It usually takes them 6 months to 1 year to obtain this commitment.
Second Stage: This stage lasts between 3 to 6 years and consists of the following:
- Sourcing – Venture capital firms focus on high potential projects. Companies may successfully attract the attention of venture capital companies through advertising in the trade press, attending business conferences and networking. Venture capital firms appoint associates or analysts to source new companies.
- Due Diligence – Sourcing is followed by extensive research on the company and its market plans. Venture capital firms evaluate and verify the accuracy of business strategies before sanctioning venture capital funds for projects.
- Investment – Venture capital firms provide venture capital funds to launch or expand companies. These companies later become ‘portfolio companies’ and a venture capital firm’s success rate is determined by the profits made by the invested companies.
Third Stage: Venture Capital funds support a portfolio company’s expansion once it has been launched and begun to show profits from sales. Portfolio companies and venture capital firms form a team driven by a common objective of increasing the invested companies’ valuation.
Venture capital firms become equity participants of the invested companies and agree on an arrangement consisting of company stocks, options, warrants and convertible securities in exchange for financing and entrepreneurial responsibility. As a member of the company management, Venture capitalists help portfolio companies draw strategic plans for expansion.
Fourth Stage: Closing is the final stage in the life of venture capital funds. Venture capital firms are required to liquidate their positions in the portfolio companies before expiration of the venture capital funds. Liquidation can be either in the form of an IPO (Initial Public Offering) realising the greatest return on investment, or buyout by a third-party.
Venture Capital Funds and the Role of VC Firms
Venture capitalists receive compensation, in return for investment of venture capital funds and management of portfolio companies, in two ways:
Management Fees: This is an annual payment made by the venture capital firms to the management corporation employing venture capitalists. General partners receive 2 to 2.5 % fee of the committed capital. The interest rate is usually lower in the beginning and rises towards the end when investment activity decreases.
Carried Interest: A net income is usually allocated based on the total venture capital funds invested. The general partners receive 20%, while limited partners receive 80% capital gains from distribution or sale of stocks of the portfolio companies.
Venture Capital funds are an important source of finance for budding businesses, as well as companies on the brink of expansion. Venture capitalists typically invest in projects with creative, untested product ideas promising high returns after efficient marketing. Venture capitalists are driven by the expectation of reaping high profits on investments from portfolio companies (usually 25 to 40% returns are expected on investment). To achieve this, venture capitalists will take up the following responsibilities of portfolio companies:
- Raising venture capital funds from several sources for portfolio companies; high net worth individuals, institutions, pension funds, investment funds, public and private endowment funds, etc.
- Management of finance and technologies, and support of strategies for marketing of products of portfolio companies
- Efficient management and safeguarding of venture capital funds. Venture capitalists generally invest in those companies or businesses in which they have prior experience. Their expertise adds great value to portfolio companies and allows greater fund security and management.