By Chase Nerison
Venture Capital is a highly selective and sought-after industry. Most outsiders understand it to a certain extent, but it is more than what meets the eye. Venture Capital is a form of private equity and a type of financing for startup companies and small businesses with long-term growth potential. One key differentiator between venture capital and other private equity deals is VC tends to focus on emerging companies in early rounds of funding while private equity tends to fund larger, more established companies. More so than just money from investors, investment banks, and other financial institutions, VCs offer a form of technical and managerial expertise.
As a major contribution to capitalism, VC has evolved from a niche activity towards the end of WWII. This has turned into a sophisticated industry spurring innovation. Though most banks were located in the Northeast when it became popular in America, it has become quite concentrated in California due to the growth of the technology ecosystem. According to Pitchbook and National Venture Capital Association’s data in 2020 Q2, West Coast companies accounted for 36.7% of all deals and 60.2% of deal value while the Mid-Atlantic region had 20.9% of all deals and approximately 18.6% of all deal value. However, the Midwest is following pursuit as the value of deals increased 265% in Denver and 331% in Chicago. Despite this competition, California, specifically San Francisco, still dominates the industry. With its proximity to Silicon Valley, the overwhelming majority of deals are in the technology industry. This includes the internet, healthcare, computer hardware and services, and mobile and telecommunications. With over four thousand active VC investors, the industry has grown 163% in the past decade, which has allowed for this growth across the country as shown below.
Diving into the activity of venture capital, they typically get involved early in seed round funding as well as Series A, B, and C, which is the chronological order of a company’s funding rounds. They will usually take a minority stake, between 25% and 50%, of the beginning company’s ownership. This capital comes from limited partners or a pool of accredited, wealthy individuals. Since this is a relatively illiquid asset, wealthy individuals can afford to hold these temporarily inaccessible assets.
The first step on the company side seeking capital is to submit a business plan. Once this occurs, the VC’s due diligence process is the deciding factor. This includes a thorough investigation of the company’s business model, management, products, and operating history. Since VCs invest large amounts in a small number of companies, this extensive research is necessary. With any investment, valuation is the name of the game. It is precisely that reason why venture capital professionals often concentrate on a particular industry to become an expert.
Once this due diligence process is finished, the firm will decide whether to commit an investment or not in exchange for equity in the company. It is common practice for the capital to come in rounds and not all at once. Once this position is processed, the firm will take an active role in the company in advising and monitoring its progress before they add additional capital in later rounds. Most VCs exit the company between four and six years after the initial investment by initiating a merger, acquisition, or initial public offering (IPO).
Since this is a highly sought-after industry, we’ll take a look at a typical day in the life as a venture capital professional. Morning meetings will consist of a firm-wide discussion of potential portfolio investments. A presentation of the pros and cons of the due diligence process will be mentioned. If that discussion is favorable, an “around the table” vote could commence within the next day on whether or not to invest in this company. Afternoon meetings involve current portfolio companies to ensure the company is performing and whether the investment is being utilized well.
Venture capital is a very important piece of capitalism as it fosters innovation and entrepreneurship. It is very risky and cost-intensive as many companies fail or underperform, but the potential for above-average returns is very attractive for VCs. Many firms follow the 2-and-20 fee structure. This is calculated by taking 2% of assets under management (AUM) and 20% of the profits. This structure allows the firm to cover daily expenses and overhead while also providing an incentive for high returns as they are paid out to the firm’s employees.
The world of venture capital is very interesting and exciting. As we have seen, some investments really pay off like Uber, DoorDash, and Airbnb to name a few. This form of financing can be highly risky, but it potentially comes with a high reward.
Bibliography
Hayes, A. (2021, November 13). What is venture capital? Investopedia. Retrieved November 13, 2021, from https://www.investopedia.com/terms/v/venturecapital.asp.
What is venture capital and how does it work? PitchBook. (2021, November 4). Retrieved November 13, 2021, from https://pitchbook.com/blog/what-is-venture-capital.
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