Venture capital is an investment of financing provided to start-up companies and small businesses that demonstrate the potential for rapid sales and earnings growth.
These investments are made by Venture Capital firms. In addition to contributing capital, VC firms may offer industry-specific management advice to improve company results.
The VC firm’s goal is to make business improvements that allow the investors to sell their holdings for a large profit within five to 10 years.
This discussion explains who VC investors are, and how they invest in businesses. You’ll also read about the expectations of a VC investor, and how due diligence is performed before investment dollars are contributed.
VC investors are often wealthy individuals with a higher level of investment experience than the general public. These are sophisticated investors, who are willing to take more investment risk, in return for higher potential rewards.
VC funding allows start-up companies, and firms with an inconsistent history of producing profits, to obtain capital. Traditional banks are not willing to fund these types of businesses, and VC firms fill the funding need.
How Investing Works
To gather assets from investors, VC firms often set up limited partnerships, with the partnership investing in the start-up company. In a limited partnership structure, the investor’s loss is limited to the original dollars invested, plus any accumulated profits.
VC firms provide funding to newer companies and start-ups, while private equity businesses typically fund more established companies.
VC investors want to see growth potential, as well as a clearly stated business plan and a comprehensive budget. It’s not enough for a business owner to simply have a good idea. The owner needs to have a well-developed plan and the ability to make informed business decisions.
Assume, for example, that Nancy owns Roadway Trucking. This company operates 100 trucks that deliver goods in the Southeastern U.S. High Plains Trucking, a competitor firm, is owned by three brothers who are near retirement and want to sell the business. Nancy sees an opportunity to expand her business by purchasing High Plains Trucking, and she want to find a VC firm to provide capital.
VC firms perform extensive research on companies, referred to as due diligence, before deciding to invest. Assume, for example, that Spectrum Venture Capital is performing due diligence on Nancy and her firm. Here are some of the items the VC firm will consider:
- Financial history: The VC firm will review Roadway Trucking’s financial statements for the past five years or more, and the potential investor may require that a CPA firm provide an audit opinion on several past years of financial statements, if an audit has not been performed. An audit opinion is a CPA’s firm’s opinion regarding the accuracy of the financial statements, and this third party review is considered reliable.
- Management team: VC investors consider Nancy’s experience in the industry, and the experience level of her management team. The management team can add a great deal of value to a business, because they can make smart decision to improve company results. Keeping a good management team in place is important to an investor.
- Investment purpose: How will Roadway Trucking use the dollars invested by the VC firm? Nancy will need to justify her business plan, and how the dollars will be invested. She will need to provide market research that supports her desire to purchase High Plains Trucking, and she must provide financial projections for the combined companies.
- Contracts: A VC firm will review Roadway Trucking’s contracts with customers, suppliers, landlords, and other parties, and the firm may uncover opportunities to negotiate better contracts with other parties.
If Spectrum Venture Capital decides to invest, they will take an active role in company management, and VC managers will likely serve on the board of the combined companies. Both Nancy and the VC investors must be clear about the VC firm’s desire to sell their investment holdings within a specific timeframe (5-10 years), and the business must be managed with that goal in mind.
A well-prepared business owner can benefit from obtaining VC funding, and VC firms fill the void for companies that cannot obtain funding through traditional banks.