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Venture capital is a method of financing a business start-up in exchange for an equity stake in the firm. The risk of investment loss and the potential for future payout are both very high. As a shareholder, the venture capitalist’s return is dependent on the growth and profitability of the business. Return is earned when the business is sold to another owner or it “goes public” with an initial public offering (IPO). The venture capitalist can then “exit” by selling his shareholdings in the company.
Due to their risky nature, most venture capital investments are done with pooled investment vehicles. Investors combine their financial contributions into one fund, which is then used to invest in a number of companies. This way, investors are diversifying their portfolio and spreading out risk. Venture capitalists are gambling that returns from successful investments will outweigh investments lost in failed ventures.
Venture capitalists are selective in their investments. Innovative technology, growth potential, and a well-developed business model are among the qualities they look for. Growth potential is the most important quality, given the high risk a VC firm assumes by investing. The priority for VC firms is high financial return and a successful exit within three to seven years.
Venture funding is most suitable for businesses having large upfront capital requirements that cannot be financed by debt or other alternatives. These characteristics usually best fit companies in high-tech industries, which explains the venture capital boom of the late 1990s. The technology firms of Silicon Valley and Menlo Park were primarily funded by venture capital. These industries saw a surge in public interest that eventually generated large returns for VC firms.
EXAMPLE
Facebook is one example of an entrepreneurial idea that benefited from venture capital financing. The Menlo Park-based firm has seen immense success since its launch in 2004. Unfortunately for Facebook’s venture capitalist investors (Accel Partners, Greylock Partners and Meritech Capital), the IPO has not performed as well as expected.Pursuing venture capital financing may not be appropriate for most start-up companies. It is important to weigh the benefits of receiving abundant resources against the costs of losing autonomy and ownership.
Advantages of venture capital include the fact that:
There are also disadvantages of venture capital:
An initial public offering (IPO), also known as a stock market launch, is the first time a private company’s shares are sold to the general public on a securities exchange. Allowing the general public to take up equity stakes in the company transforms it from being privately traded to publicly traded. If the company was venture-backed, the VC firms often gain their returns from IPO yields. Usually, the VC exits investments within a short time (one to three years, normally) after the IPO is concluded, either by distributing the shares to VC fund investors or selling them off on the market.
IN CONTEXT
This is the Initial Public Offering (IPO) Prospectus for Apple Computer Inc. in December 1980.
A total of 5 million shares were offered to the public for $22 each. The total outstanding shares after the offering were 54,215,332. The company’s officers, directors, and major shareholders held 32 million shares and the rest were held by the company for stock options, plans, and other needs. Apple’s valuation after the IPO was over $1 billion. (54 million shares at $22.)
Going public can also have benefits for the company, including:
IPOs are not without cost to the company. Disadvantages to completing an initial public offering include:
Prior to agreeing to provide capital, venture capitalists contract for privileges including registration rights, which ensure their ability to sell shares into the public capital markets, thereby safeguarding their future returns. Prior to selling shares on the stock exchange, companies must register these shares with the Securities and Exchange Commission. The registration rights agreement between the company and the venture capitalists requires the company to register the offering of shares by venture capitalists under certain conditions.
These conditions may be in the form of:
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