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What is Venture Capital, and How Does it Work?

Whenever starting a business, a person sees himself in somewhat dire need of funds to run it efficiently so that it hogs some profits.

One option here is loan from banks, which, however, grants the funds only on the basis of hard assets (machinery, vehicle, factory etc.).

And this happens to be a turn-off for the entrepreneurs, since most of the enterprises today are not in possession of such assets.

Here appears into the scene VC or Venture Capitalists. Often confused with individual angel investors, VC is a firm meant for investing in startups and early-stage companies.

Let’s dig this in further.

What is Venture Capital?

Private companies financing private enterprises that are not catalogued on the stock exchange is what makes the venture capital.

These VC companies are ever on a lookout for new, potential startups/ businesses often related to tech arena and in raising funds to invest in them.

Quite similar to Private Equity (PE) Venture capital focuses on newborn enterprises or those in early phases.

This makes the business too risky, but if the idea succeeds, the profits are also tremendously high and impressive.

PE (private equity) on the contrary, are more concerned with later stage firms, and thus involves low risk.

The name itself includes ‘venture’ which aptly suits to the nature of its function.

Venture Capital bridges the gap of fund availability from the banks, since they only lend the money against hard resources.

This definitely renders getting loan from banks problematic.

Another reason for bank’s reluctance in lending funds to startups is high risk, and thus they levy heavy interests, making the borrower retract their steps.

While these young companies find refuge in VC firms, which is always ready to play this high-peril game.

And in turn, claim some stake in the company, rather than issuing the fund as loan.

Further, the professionals in VC also provide plans, strategies and relevant resources for the startup or young business to thrive unlike a bank.

How does Venture Capital function?

A venture capital firm raises a fund from the limited partners like pension funds, insurance firms, etc.

The pooled money is then invested into startups which may potentially yield appreciative returns in the future.

Venture capital involves two complimentary partners, limited and general partners.

Let’s acquaint them to you in a bit detail:

Limited Partners

This includes people or organizations having wealth to invest, such as pension funds, insurance enterprises, etc.

These companies capitalize only some of their available cash into a Venture Capital company, which subsequently puts the money into various startups.

They prefer to invest in VCs anticipating really scaled returns than, real estate, public equity markets, debt funds etc.)

The limited partners (LP) however do not invest lion’s share of their money to VC, rather it is just 5-10% of it.

General Partners

General partners of VC then, analyse and strategize things, bringing potential partners and investors, and talented human resource, to bring the business closer to booming success.

GP (general partners) are general professionals working in the VC firm.

They handle jobs like finding potential startups, raising funds, helping the company flourish and finally either by selling the firm to another company or investor.

Let us grasp the working of venture capital elaborately.

Venture capital firms take into account the specific stages of startup or business while financing them.

Seed Stage

VC at this phase offers a slight finance to carry out things like product development, business plan development, or market research.

This funding by VC is also called as its seed round.

The investors of seed round typically get either equity, convertible notes or other stock options for their funds.

Early Stage

The VC firm, here, sets eye over companies that are developing and hence capitalize relatively more funds than the seed stage.

Here the money is intended to smoothen the functions and plans to better promote their product or service.

Venture capital in early stage is put in stepwise rounds aka series A, series B and so forth.

Late stage

The VC firm here target mature enterprises which show some signs of becoming successful in future.

For this, the track record and other factors of the company are scrutinized well before investing.

GPs understand if the company will generate profitable income and has better prospects.

The financing here is also done in rounds named like series A, series B, series C and so forth.

Also Read: How company decision can affects stock price? 

Fund life in Venture Capital

A fund sustains from around 7-10 years, then after that it has to return the money to its limited partners. The time frame is set, keeping in the mind the required growth span for a company to establish itself and start earning some profits.

First 2-3 years are expended in locating and choosing the potential startups in which the VC should capitalize, while the next 3-4 years are gone in setting the foot and winning some gains.

After this, the GPs or VC has to exit the funds and generate wealth.

The VC charges management fee from LPs for their efforts and expenses like salaries of staff, office rent and other bills to operate the account, which is about 2-3% of the fund worth.

But, how do Venture Capital Companies make money?

Venture capital firms as we just discussed charge some percentage of the fund value as a management fee.

They also receive performance fees, which can be different depending on the fund.

Management Fee

This fee is used to meet the expenses of the firm, like salaries, office rents and bills, admin and analyst’s requirements, etc.

It is a percentage of Assets under management (AUM) which makes it about 2%.

Performance Fee

This charge is basically a reward given to employees to encourage them to gain higher returns.

It is a percentage of profits from invested capital, which is around 20%.

Bottom line

So, in a nutshell, this write-up focused on venture capital, and its working.

Quite an interesting subject to discuss, venture capital firms, ‘venture’ into early-stage companies or startups that may thrive in future with their funds.

These funds are raised from the limited partners for about 7-10 years. After this fund life, the money is returned with the profits.

And finally, you are here having enough knowledge on venture capital.

By the way, are you planning to make some startup?!

Further Reading:

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