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  • Writer's pictureEden Chan

What is Venture Capital?

We’ve all heard the term ‘venture capital’, but what does it really mean? For many, images of high-powered technological innovation, Silicon Valley offices, and garage startups are brought to mind. Although it’s often true that venture capital is used to fund tech startup companies, venture capitalists of all varieties are becoming increasingly common. If you’re at all interested in the world of venture capital, read on!

What is venture capital?

At its core, venture capital (VC) is a form of private equity – investment in companies and organisations that are not publicly traded. Crucially, whereas other forms of private equity may involve investment in large-scale private organisations, venture capital only pertains to startup companies and small businesses. Often times, venture capital is sourced from well-established private equity firms and investment banks, although investment may also be derived from specialised venture capital firms. Note also, that while most venture capital is monetary in nature, it can also be provided in the form of technical or managerial expertise.

How does venture capital work?

At its most basic level, venture capitalists pledge capital in return for an equity stake in a company. Depending on the nature of the investment, investors may take up a managerial position within the company they have invested in (e.g., an investor might join the board of a startup upon investment). Alternatively, investors may take on a more advisory role within the company. With this being said, no matter the investor-investee relationship, all venture capitalists aim to generate profit and enhance value in the companies they invest in. Generally speaking, venture capital funding takes the form of the following process: 1. Pitch deck: investees deliver a short presentation outlining their proposal. This is an opportunity for companies to persuade venture capitalists to invest in their product or idea. 2. First call: the first call is a preliminary opportunity for investors to meet investees. Pending the outcome of this call, investors may enter negotiations and further discussions with company management. 3. In-person meeting: venture capitalists often want to know more about the people they are investing in. A face-to-face meeting provides an opportunity for the investor and investee to meet and connect on a more personal level. For many investees, this meeting is make or break. 4. Follow-up meeting: if investors see potential in the first in-person meeting, they’ll arrange a follow-up meeting to confirm the details of the investment arrangement. Depending on the magnitude and nature of the investment, many follow-up meetings may be necessary. 5. Offering documents are sent: if an investor or VC firm decides to invest, offering documents are sent off to the company being invested in. Such offering documents outline the contractual obligations of the investee, as well as any terms and conditions surrounding the investment. 6. Cash/resources/assets are transferred: presumably, after discussion and legal counsel, any cash, resources, and/or assets being invested in the company are transferred, and a formal equity stake is granted to the investing individual or entity. Alternatively, if an investor offers technical or managerial expertise, their equity stake will be granted provided such expertise is continually provided to the company. The expectations of such expertise and support are usually outlined within the previously mentioned offering documents.


Why venture capital?

So, you might ask, if venture capital investment is so risky, then why even bother? The answer is simple: companies with exceptionally high growth potential offer higher returns. In other words, although classic ‘blue-chip’ stocks offer largely positive annual returns, such returns are often limited in nature. Conversely, in the world of venture capital, small companies may grow to produce returns many magnitudes bigger than traditionally possible. Take, for example, Jack Ma’s Alibaba. In 2000, SoftBank’s venture capital division invested some $20 million into the company. Note here that – in 2000 – Alibaba was a strictly private company, with no publicly traded shares. With this being said, when Alibaba finally decided to offer public shares (and by extension, become a publicly-traded company) in 2014, SoftBank’s stake in the company was valued at well over $231 billion dollars. At the end of it all, SoftBank made an average annual return of 825% - a seemingly astonishing feat compared to traditional investment methods and strategies. Had SoftBank chosen to instead invest in an existing publicly traded stock, it’s likely that they would have experienced far less return on investment. Now, you’re probably thinking ‘if venture capital is so lucrative, then why even bother with other methods of investment?’. Very simply, because it’s risky. Although we often hear about astronomical returns on venture capital investment, these instances are rare, to say the least. In actuality, venture capital is an incredibly risky method of investment, with as many as 30% of venture capital endeavours failing completely. At its most fundamental level, venture capital is risky for three reasons: 1. Market trends: By their very nature, companies receiving venture capital are often at the forefront of technological innovation. However, while such companies may be hugely profitable when successful, various market trends may disrupt further interest from other venture capitalists. In other words, although a company’s idea might be attractive for investors in 2021, there is no guarantee that it will be attractive in 2025 or 2030. Take, for example, the gig economy (think: rideshare companies, temporary accommodation services, etc.). In 2015, Airbnb, a vacation rental online marketplace, raised over $1.5 billion in venture capital funding. Principally, Airbnb’s revenue depends on consumers’ willingness to take vacations and holidays. Of course, throughout the recent Covid-19 pandemic, Airbnb’s consumer base has fallen significantly and – as can be expected – so has its investment. Whereas investment in the gig economy was once significant, investors now desire companies tailored towards life in a world with Covid-19. As such, market trends pose a considerable risk to venture capitalists. 2. Corporate management: Venture capitalists are very rarely experts in the field of the company they are investing in. As such, effectively assessing the skills and capabilities of corporate management (e.g. Chief Executive Officers) is often difficult. Unless investors have formed a previous relationship with the corporate management of the company they invest in, it’s almost impossible to predict the long-term human behaviours of the company’s leaders. Whereas executive boards of well-established public corporations are littered with highly successful corporate leaders, small-scale startups are often managed by young, relatively inexperienced businesspeople. This unpredictability poses a somewhat significant risk to venture capitalists. 3. Financial insecurity: All companies face challenges. Government regulations, market forces, and real-world issues give rise to financial problems in almost every company. For large corporations, however, such issues are easily solved, primarily as a result of relatively massive amounts of financial backing. Although companies with venture capital investment may have multi-million-dollar valuations, it’s unlikely that they will be able to manage a catastrophic market event to the same degree of success as a larger, more financially secure organisation. Such insecurity enhances risk exposure for venture capitalists.

Summary

In an increasingly innovative market, the venture capital industry is positioned to grow considerably. Venture capital is a form of private equity backing intended to provide startup companies and small businesses with the necessary capital to develop its product and return profits to investors. After a period of negotiation, investors (either in the form of an individual investor or a larger venture capital firm) transfer monetary or expertise- based resources to companies, which is then utilised by the company to develop its product and expand. Despite being a relatively risky investment, venture capital investments have the unique potential to generate returns many thousands of times bigger than the original capital investment. No matter the risk, venture capital is an exciting frontier of business that can’t be missed!

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