What’s it: A venture capitalist is a professional investor who invests in a new company, startup, or young company, in exchange for ownership. They are risk-takers because they invest money in high-risk businesses.
New companies are at risk due to uncertainty about their survival. Some companies may be successful and grow to be big, but many also fail before they grow and develop.
Moreover, as they grow, venture capitalists also have to face other uncertainties. The rate of return obtained may not be as expected; for example, the company is not successful in competing and produces only a low profit.
In compensating for this high risk, venture capitals target a high target rate of return. Therefore, they will choose a high-growth-potential business, so it is profitable to sell later.
How venture capitalists work
Investors provide funds and raise them in venture capital funds. They usually come from large financial institutions such as pension funds, financial companies, insurance companies, etc. Also, funds may come from wealthy individuals with a high-risk tolerance.
Money is pooled together and managed under a venture capital firm, determining where the money is invested.
To allocate funds, venture capital firms form a committee. They are tasked with making investment decisions, identifying and selecting potential companies to fund. Once identified, capital injections flow to the target company and often require a substantial shareholding.
Venture capitalists are not long-term oriented. They invest until the company reaches an adequate size and competitiveness. So, they can sell it at a profit and use the proceeds to invest in other companies.
A venture capital firm may still retain a percentage of ownership and not sell all of its shares. However, in most cases, they sell entirely to other buyers or until the company is ready to issue initial shares on the stock market.
Basically, they buy stock and own it for a short time until the company is eligible to sell at a profit. The faster the company grows, the faster they can sell it.
Characteristics of the target company
Venture capitalists generally don’t fund startups from the start. Their target is growth companies and needs funding to develop their business. So, they don’t get involved with the owner to set up a business and build management from scratch.
However, when compared to private equity, the target company is usually younger. Private equity usually funds established companies. They have been operating for several years but do not yet have access to the capital market (unlisted company).
Due to the high risk, banks are usually less interested in funding young companies. At the same time, the owner needs external funds to finance expansion, such as to add new machines or open a new distribution network. Internal cash is inadequate, and companies do not have access to equity markets. Therefore, venture capitalists are here to cover the funding gap.
Venture capitalists are selective in choosing target companies. Three essential criteria for target companies are:
- Operating on a market with high growth opportunities
- Have a strong management team
- Offer a unique product or service with a strong competitive advantage to supports long-term growth
Selection of target companies
Choosing a target company is the most challenging stage. It may take months to study the target company’s core business, management, operations, strategy, and business environment. Failure in this process can result in substantial losses or non-target rates of return and investment tenure.
For selection, venture capitalists look for companies in the industry they are familiar with. That may be the industries they have been funding. That way, they have a more in-depth knowledge of potential risks and returns.
Apart from that, they also want their funds to generate more money. For that reason, they will choose the target companies that offer significant shareholdings. That way, they can influence the direction of their policies to support profit targets.
Returns for venture capitalists
Venture capital is not debt like a bank loan or corporate bond. It is the equity in which, when injecting funds, the venture capital firm acquires ownership. Thus, the only way to obtain returns is through appreciation of firm value. When the company value goes up, venture capitalists can sell their targets profitably.
The source of income from dividends is also unlikely. Target companies often still have negative operating cash flows due to high operations.
The rate of return varies. For 1-2 year funding, venture capitalists expect a tenfold return on capital over five years. Meanwhile, a return rate of 12% per year is considered good, and 7-8% per annum is considered a safe return.