Venture capital is a very powerful entity in the financial world today. The money which forms venture capital is raised from wealthy individuals (also known as limited partners) who want their money to be invested in a more professional and efficient way.
Early stage, expansion and buyout capital are the three main categories of venture capital. Early stage capital is used for establishing the venture whereas expansion capital is used when the enterprise is established but needs to grow laterally. Buyout capital however is a form of capital where a firm gets taken over in all respects and is indeed, bought out.
Having seen basic categories of venture capital money, let us now take a look at how this money is raised and then used in the venture capital market.
Venture capital firms offer professionally administered funds for seed, startup and expansion financing. The money may be used to specialize in technology sectors as well as other areas like the service sector, financial organizations and so on.
Venture capital firms are basically partnerships investing money of their limited partners. The sources may be corporate pension funds, wealthy individuals, foreign investors, or even governments. Once raised, the money gets placed in a fund. Usually a fund might close at say, $300-$500 million. The investment may continue for three to five years. Investors in venture capital funds have very specific requirements for the returns on the initial capital invested. A venture capitalist should evaluate potential investments with the same objective in mind. This is why aventure capital firm will play an active role in running of the company which is being developed and the members of the firm will probably have a seat on the board of directors.
Venture capital funds have a limited lifespan – usually up to 10 years with an extension of maybe a few more years in some exceptional cases. The actual investing cycle for most funds is usually three to five years. After this, the investor will concentrate on the development of the funds that are already in place. This system was pioneered successfully by funds in Silicon Valley, California during the 1980’s. The strategy adopted here was that theinvestment would be in technology but only at the point of maximum growth.
In the startup, when investors get involved with the fund the actual investment may be unfunded. The investors may have to put up some capital from their own pocket. There are considerable penalties for defaulting limitedpartners during this period.
For venture capitalists to actually raise money from their limited partners may take from a month to a year. When all the money has been raised, the fund considered “closed”. The fund’s ten-year lifespan usually starts from this point. The "Vintage year" generally refers to the year in which the fund was closed and will set the timelines for the business plans for the years to come.
Any discussion on venture capital money would not be complete without touching briefly upon the system of compensation. Venture capitalists are remunerated through a combination of Management fees and interest accrued.
Carried interest: This is a percentage of the profits which is given to the venture capitalist on a monthly or annual basis usually 20%. The remaining 80% of the profits goes to the fund's investors.
Management fees: The fund manager gets paid annually for the private firm's investment operations like a regular salary. Typically this will equal to up to 2% of the committed capital.
Thus the entire funding process of a venture capital firm becomes clear – how the different types of capital is used in the various stages to convert the firm into a commercially viable profit centre.