Venture capital supports entrepreneurial talent and appetite by turning ideas and basic science into successful products and services. Venture capital is an important source of funding for start-ups, since they have a limited operating history, and hence don’t have access to the capital markets. It helps reduce the time required to bring a product to market.
Over the years, venture capital has gained widespread recognition in the United States, especially in rapidly expanding industries like software, telecommunications, semiconductors, medical devices, biotechnology and life sciences. Some of the most innovative and successful companies such as Amgen, Apple Computers, Cisco Systems, Compaq, eBay, Federal Express, Genentech, Genzyme, Gilead Sciences, Intel, Microsoft, Netscape, Sun Microsystems, Staples and Yahoo received venture financing.
Venture capitalists (also known as VCs) typically invest in young, private companies that show exponential growth potential, in exchange for an equity stake. A VC would typically look at answers for the following when considering investing in a business:
- Who are the team members?
- Is the business commercially viable?
- Does the product have an identifiable market?
- What is the market size
- Who are its competitors?
- Is there a competitive advantage?
- What is the growth potential
- What are the exit prospects
VCs also look at other factors such as outcomes of past operations, funds needed, burn rate, earnings projections and economic conditions.
Risk v/s Return
A key factor for the VC would be risk versus return. The earlier a VC invests, the greater are the inherent risks and the longer is the time period until the VC’s exit. Entrepreneurs bootstrap their business idea by getting the seed funding from friends & family, or angel investors. It is once they have proof of concept that the VCs are approached. VCs seek companies with an objective of achieving at least a 10x return on their investment over 3-7 years, given the risks involved. Not all VC investments pay off. In fact, anywhere from 20% to 90% of most portfolio companies may fail to return on the VC’s investment. However the few which do end up living to their potential are the ones that help VC funds make their returns. In the best VC funds, 33% succeed, 33% break even and 33% fail.
Venture capitalists provide equity investment and therefore share in both the profits and losses from innovation. They also have an active involvement in the portfolio company’s strategic, recruiting and managerial decisions, by taking positions on the company’s Board of Directors. Along with capital, VCs also bring their understanding of technology and industry connections to their portfolio companies.
To make money on their investments, venture capitalists need to turn illiquid stakes in private companies into realized returns. Typically, this happens when the company goes public (IPO) or is merged or purchased by another company (M&A).
Venture capital activity has a significant impact on the U.S and global economies. It is a catalyst for job creation, innovation, technology advancement, international competitiveness and increased tax revenues. Some of the most innovative companies today would not have existed had it not been for venture capital. Experts agree that virtually the entire biotechnology industry and most of the significant breakthroughs in the medical industry would not exist without the support of the venture capital industry.
Small venture backed companies often serve as the research and development (R&D) pipeline for similar larger corporations that seek to acquire the most promising innovations. Whether these emerging companies someday grow to the size of a Fortune 500 corporation or are acquired for their groundbreaking products, they all rely on the venture capital industry to get their start.