Venture Capital: How It Works, How It Makes Money, Investment Horizon

What’s it: Venture capital is capital invested in a new company, startup, or young company, in return for ownership. It is a form of private equity besides leveraged buyouts (LBOs), minority equity, and distressed investing. Venture capitalists take a risk by investing money into a high-risk business and expecting it to come with a significant return.

Venture capital firms raise funds from investors, such as pension funds and insurance companies. Wealthy individuals and other accredited investors are other sources. They then invest the funds into private companies, which may be seed financing, early-stage financing, later-stage financing, or mezzanine-stage financing.

To compensate for the high risks faced, venture capitalists require high returns. Therefore, they choose businesses with high growth or strong cash flow potential. In addition, they also desire controlling interests and pursue protective provisions to influence critical decisions. Thus, venture capitalists can be actively involved in running the business after capital has been injected into the target company. Often, they sit on the board of directors and assume key management roles. The goal is to make the target a profitable company when it is sold at a later date.

Why is venture capital important?

Startups or young companies have a high risk. Their internal cash is insufficient. In fact, generally, they operate by relying on cash flow from investments. Their operations have not generated sufficient cash inflows to cover costs. As a result, they still report negative net cash flow.

These risks make startups or small companies less attractive to conventional investors such as banks. High risk makes banks less interested in funding them.

Startups and emerging companies also do not have access to capital markets. Again, their risk is high. They may find it challenging to raise capital by issuing bonds or issuing stock.

But, at the same time, founders need external funds to finance the business. For example, they need funds to develop products and strengthen marketing. Or they need it to expand.

In this case, venture capitalists exist to cover the funding gap. They dare to take high risks by financing startups or young companies.

What is the difference between venture capital and private equity?

Private equity is the investment vehicle by which investor capital is pooled and invested in private securities. Investing in private securities differs from hedge funds, which focus on public securities.

Private equity targets non-listed or publicly traded companies. Nonetheless, some may target publicly traded companies and make them private by purchasing a controlling stake.

Private equity is divided into four based on their strategy, namely:

Leveraged buyouts (LBOs) – acquiring target companies by relying on debt.
Venture capital – investing in young companies or startups.
Minority equity investing – focusing on more mature companies by providing funds to help target companies grow.
Distressed investing – targeting companies in financial distress and may play an active role in helping them out of financial distress.

Long story short, venture capital is a form of private equity focused on young companies or startups. Venture capital firms may engage in seed-stage financing, providing capital to support product development and marketing efforts. Alternatively, they engage in later stages, such as early-stage funding, to finance the business going into operations before commercial production and sales and later-stage funding to provide capital after the business begins commercial production and sales.

Why do venture capitalists face the substantial risk?

The venture capitalist’s strategy comes with substantial risk. There are several reasons why their investment involves significant risk. First, the target is at high risk because its survival is uncertain. Despite having high growth potential, the target company does not yet have steady cash inflows. In addition, they must face risks such as:

No customer base
Loyalty has not been built
Low economies of scale
High competitive pressure

The risk is greater if venture capitalists are involved in seed financing, such as seed-stage financing, where they support the business in developing product and marketing efforts to build a customer base. I mean, they fund the business even when the target hasn’t made any money yet.

The above risks expose uncertainty about survival. Some targets may be successful and grow to be big, but many fail before they grow and develop.

Second, say the target company is growing. However, the rate of return obtained may not be as expected because the target failed to generate the targeted profit. For example, the target fails to compete with other new or established companies. Or, they must compete on price to capture and strengthen their customer base, lowering profit margins. As a result, they made little profit, making the return on invested capital low.

What are examples of venture capital?

Here are the Top-10 largest venture capital funds in the world:

General Atlantic: $31 billion
Hillhouse Capital Group: $30 billion
Insight Venture Partners: $18 billion
Iconiq Capital: $14.5 billion
New Enterprise Associates: $10 billion
Tiger Global Management: $10 billion
Transition Level Investment$: $10 billion
Norwest Venture Partners: $7.5 billion
Andreessen Horowitz: $7 billion
Institutional Venture Partners: $7 billion

For other examples, you can see the complete list at FundComb.

How do venture capitalists make money?

Venture capitalists make money from management and performance fees, their primary sources. Management fees are based on the funds they manage. Typically, venture capitalists charge 2% of the total funds committed by accredited investors. Sometimes, the percentage is based on the funds invested.

Meanwhile, the performance or incentive fee is based on the profits derived from the funds invested. The amount is usually 20%.

These percentage-based fees explain why venture capitalists can make so much money. Let’s take a simplified illustration. For example, they manage a $1 billion fund. They earn $20 million yearly (2% x $1 billion) in management fees. If the fund makes 30% a year in profits, they earn an additional $60 million in revenue (30% x $1 billion x 20%).

How does venture capital work?

Venture capitalists invest in startups or young companies with high growth potential and are able to generate robust and rapid cash inflows. For example, they invest in technology-based companies such as health tech and life sciences, ag-tech systems, and advanced manufacturing.

Where do the invested funds come from? Venture capital raises funds from investors. The money is pooled together and then managed under a venture capital firm, which determines where the funds are invested.

Venture capital firms typically have a committee tasked with making investment decisions, including identifying, screening, and selecting target companies for funding. Once selected, the venture capital firm injects funds into the target company, often with privileges.

These privileges are crucial to influencing critical decisions within the target company. The goal is to secure their investment. In addition, venture capitalists also have an interest in making the target of becoming a more mature and profitable company to sell.

Once it is deemed profitable enough to sell, the venture capital firm executes an exit strategy. The common way is to sell to the public by listing shares on the stock exchange (Initial Public Offering or IPO).

Source of funds

Venture capital firms raise funds from major financial institutions such as banks, pension funds, and insurance companies. In addition, they may also raise funds from wealthy individuals with a high-risk tolerance.

These investors invest in venture capital funds to diversify their portfolios and generate high returns. However, compared to investing in public securities, investing in venture capital requires a long-term commitment. In addition, these investment vehicles are relatively less liquid and regulated than stocks or bonds. For this reason, investors expect high returns on their investments.

Invested capital

Venture capital firms usually provide equity capital. In addition, they seek to acquire voting rights and a controlling interest. Thus, after the money is injected into the target company, they can actively influence its strategy and running.

In addition to common stock, the injected capital may be convertible preferred stock. Or, it is convertible debt. For example, under convertible debt, unlike conventional bank loans or bonds, the target company grants venture capitalists the right to convert their loans into equity and, therefore, represents an ownership interest in the target company.

Investment horizons

Venture capitalists are long-term oriented. But, their investment horizon varies, generally around 10 years. Some may have a 7-year horizon.

Regardless of their investment horizon, venture capital firms are concerned with achieving profits as quickly as possible. For this reason, they invest in companies with high growth potential or the potential for strong and fast cash inflows. And they invest until the target is of sufficient size and competitiveness. Long story short, the target is feasible to make the targeted profit when it is sold. The sooner the business reaches maturity, the better because the invested capital achieves the targeted return faster.

In most cases, they sell entirely to other buyers or until the company is ready to issue initial shares in the stock market. They then use the proceeds from the sale to invest in other companies. However, in specific cases, they may still retain their ownership percentage and not sell their entire holding, hoping to recover the dividends distributed.

Long story short, a venture capitalist invests in a young company and owns it for a short time until the company is fit for sale at a profit. The faster the target company grows, the quicker it can sell at the targeted profit level.

Target company

Some venture capitalists may not fund startups in the first place. In other words, they don’t engage with the owner to set up the business and build management from scratch. Instead, their target is a company in the growth stage and needs funding to grow the business. As a result, they might come in after several funding rounds before the company IPO.

However, venture capitalists inject capital in some specific cases, such as seed and early-stage financing, since product development and moving toward operations but before commercial production and sales have started.

Target company criteria

Choosing a target company is the most challenging stage. Studying the target company’s core business, management, operations, strategy, and business environment may take months. Failure in this process could result in substantial losses and under-target returns.

Several criteria are essential when venture capitalists are selecting targets. First, the target operates in an industry they are familiar with. Those are probably the industries they have funded so far. This choice makes more sense because they understand the potential risks and returns involved.

Second, the target’s market has high growth potential. Thus, their market does not immediately reach the mature stage. That way, the target can make money in the long term. In addition, high growth potential usually comes with relatively low competitive pressure because there are still many new customers to be acquired.

Third, the target has a strong management team, enabling the business to grow with credible people. Fourth, the target is to offer superior products and value propositions. Thus, there are reasons for consumers to continue to buy products and prefer them over competing products.

Fifth, competitive pressure is relatively low, either by more established players or potential entrants. This is important because high competition squeezes profit margins, leaving less profit to be made.

Sixth, the target offers shares with significant voting rights. That way, venture capitalists can influence business policies and operations to support profit targets.

Return on investment

Venture capital funding is not debt like a bank loan or corporate bond. Instead, it is equity, where the venture capital company acquires ownership when injecting funds. So where do venture capitalists get returns on the funds they invest?

Earning income from dividends is less likely because the company is still in its infancy. In addition, target companies often still have negative operating cash flow due to high operating costs. Thus, the only way to get a return is to sell it at a higher price than bought for, which is achieved when the target firm becomes more valuable. For this reason, it is in the venture capital firm’s interest to quickly grow into a company with solid cash flow or a strong market position.

What is the rate of return earned? The percentage varies. For 1-2 years of funding, venture capitalists expect a ten times return over five years. Meanwhile, a return rate of 12% per year is considered good, and 7-8% per year is considered a safe return.

How to sell the target company? Venture capitalists usually rely on IPOs as an exit strategy. They offer the target company’s shares to the public through the stock exchange. Or they sell to other companies. The alternative is through a management buyout where the target company’s management takes control.