Understanding Venture Capital
Venture capital is a type of private equity funding that is given by venture capital companies or private funds to budding entrepreneurs, mid-stage, or emerging firms that are deemed to have exceptionally high growth potential or that have proven unexpectedly high entrepreneurial success. Usually, venture capital funds invest in the early stage of a venture. These companies are usually those with strong financials that can readily meet initial business requirements and which have a proven track record of generating profits. As such, venture capitalists usually prefer to support small, newer businesses.
Venture capitalists work as private equity owners, unlike conventional ownership models. Their investment in these enterprises is not based on personal likings or on their own knowledge of the company. Instead, it is based on their assessment of the company’s capital structure, management capabilities, business plans, market and customer demands, and other factors. Because of this similarity to other forms of equity investment, there are some differences in venture capital funding, especially as regards the methods of valuation used.
The most prominent type of equity funding is disclosed equity. Disclosure Equity, as it is often referred to, involves exchanging shares of the company’s common stock for cash and/or a portion of the company’s assets. The amount of equity capital provided by venture capitalists is based largely on the valuation of the company. Once venture capitalists determine the value of a business, they notify the venture capital firm or angel investors of their valuation. The venture capital firm or angel investors then decide the amount of capital to provide to a company.
Another type of equity finance is referred to as working capital. This is the portion of a company’s resources that are used to conduct normal day-to-day operations. A good example of a working capital loan is a commercial truck loan, which may be made by some private equity firms and venture capitalists. Angel investors and venture capital firms typically fund an entire business through these means, rather than providing individual loans to individual entrepreneurs.
Private investors also provide seed money and seed business funding. Seed money is given to an aspiring company in exchange for a percentage of the business in return for early venture capital. In order for this to be a successful arrangement, the venture capitalist must have an established track record of success in making early investments. Seed business funding, on the hand, is typically provided by angel investors or venture capital firms. Once again, the amount provided will depend on the valuation of the business.
In the final phase of venture capital financing, a convertible bond usually is issued by an angel investor or venture capital firm. This type of equity investment occurs when the equity of the company is sold to a third party. The convertible bond, which takes the form of a debt security, is then converted into shares of the issuing company’s stock. As previously stated, this conversion is usually funded through an angel investor or venture capital firm. As in the previous phases of venture capital, much of the funding for convertible bond transactions comes from private investors rather than venture capital or angel investor groups.