Venture Financing:

Debt vs. Equity

Venture Capital Firms

Professional Investment Risk Managers Agents Between Capital Sources and New Enterprises

By Venture Planning Associates. Used by permission.

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Venture Financing

Venture capital is high-risk, high-return investing in support of business creation and growth. 

 

In pursuit of high returns, a venture capital ("VC") firm raises a fund of anywhere from $10 million to $350 million in size for their first fund.  Later these funds may grow to the billion dollar size and above.

The legal structure of a VC fund is a limited partnership, limited liability company or limited liability partnership.  Those who invest money into the fund are known as limited partners (LPs).  Those who invest the fund's money in developing companies, the venture capitalists, are known as general partners (GPs). 

Generally, the LPs contribute 99% of the committed capital of the fund while the GPs contribute 1% of it.  As returns are made on the fund's investments, committed capital is distributed back to the partners in the same percentage.

VC firms receive compensation for their investment and management activities in two ways.  First, they receive an annual management fee paid by the fund to a management corporation which employs the venture capitalists and their support staff.  The annual management fee approximates 2.5% of committed capital; however, it is usually lower at the very beginning and end of the fund when investment activity is low.  Secondly, the VC firm receives compensation through the allocation of the net income of the fund.  The fund's primary source of net income is capital gains from the sale or distribution of stock of the companies in which it invests.  The GPs typically receives 20% of net capital gains while the LPs receive 80%.

 

A venture capital fund passes through four stages of development that lasts for a total of ten years.  The first stage is fundraising.  It typically takes the GPs of a venture fund six months to a year to obtain capital commitments from its LPs.  LPs include state and corporate pensions funds, public and private endowments, and personal investors.  

The second stage lasts between three and six years and is comprised of sourcing, due diligence, and investment.  When a VC firm sources a company, it simply means that the company has been brought to the attention of the firm. Sourcing occurs through reading trade press, attending trade conferences, and speaking to those with industry familiarity.  A junior member, a.k.a. an Associate or Analyst, spends the majority of his/her time sourcing companies.  After a GP or junior member sources a prospective deal, extensive research is done on the company and its market.  Occasionally this process, called due diligence, leads to an investment.  Companies in which VC firms invest become "portfolio companies."

The third stage, which lasts until the closing of the fund, is helping portfolio companies grow.  The portfolio company and the VC firm unite to form a team whose goal is to increase the value of the portfolio company. 

 

The VC firm becomes an equity participant in the portfolio company through a deal structure typically comprised of a combination of stock, warrants, options, and convertible securities.  In return, the VC firm provides financing and a representative who sits on the portfolio company's board.  As a board member, the VC representative offers strategic advice to the management team and assures that his/her firm's interests are considered.

The fourth and final stage in the life of a venture fund is its closing.  By the expiration date of the fund, the VC firm should have liquidated its position in all of its portfolio companies.  Liquidation usually occurs in one of three ways: an Initial Public Offering (IPO), the sale of the company to a third party, or Chapter 11.  Typically an IPO realizes the greatest return on investment.

 

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