Learn the Ins and Outs of VC Investments

written by: Doreen Marteledited by: Jean Scheidupdated: 5/23/2011

New business owners often face difficulties in obtaining capital. Some turn to venture
capital (VC) options to help them get started. Before you use this type of investment
to fund your business, make sure you understand the advantages and disadvantages.

Understanding Venture Capital

If you are looking for ways to fund your business, do you understand venture capital,
its advantages and disadvantages? If not, here you will find all you need to know as
well as the pros and cons of this type of funding.
Venture capital is also known as seed capital or private capital. It is mostly used to
help businesses that have high potential for growth. One company that is no stranger
to most people is Digital Equipment Corporation (DEC) which was founded in 1957
using venture capital funds obtained from George Doriot who owned the venture
capital firm American Research and Development Corporation (ARDC).
Venture capital funds are used primarily for companies who may not have sufficient
operating history to qualify for traditional loans through a bank. Most start-up high
technology companies have used venture capital funds in order to get started. In
most cases, these companies are required to provide the venture capital company
with a form of profit sharing by providing the venture capital firm equity in the
company.
Venture capital funds are not easy to obtain. In fact, most business owners who apply
for venture capital funds will be turned down. Unless a business plan can easily
demonstrate high rates of return within a five year period, chances are very good
that the request for venture capital funds will be turned down.

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The Pros of VC
There are some benefits to venture capital funding. In many cases, the company able
to secure venture capital funds can receive services that may include:
Business Consultations - Many venture capital firms have consultants on their staf
that are well versed in specific markets. This can help a start up firm avoid many of
the pitfalls that are often associated with start-up business ventures.
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Management Consultations - Unfortunately, not all entrepreneurs are good

business managers. Since venture capital firms almost always require a percentage
of equity in the start-up firm, they likely will have a say in how the firm is managed.
For the non-management expert, this can be a significant benefit.
Human Resources - In terms of finding the best talent for start up firms, venture
capital firms often provide consultants who are specialists in hiring. This can help a
start up firm avoid the pitfalls of hiring the wrong people for their company.
Additional Resources - Starting a new business is fraught with concerns about
legal matters, payroll matters, and tax issues. It is not unusual for a venture capital
firm to take an interest in providing these resources since they have a vested interest
in the success of the company.
In general, business resources that are provided by venture capital firms who have
taken an equity position in a start up company can be invaluable to the success of
the company. Many start up firms securing venture capital are able to thrive and
become giants in their industries.

Cons of Venture Capital

Securing venture capital typically means that you have to give

up something in exchange for the funding. Most venture capital firms are not
interested in merely receiving the capital that they have invested along with a
standard interest rate. In fact, there are some things that venture capital firms may
ask for that may surprise you. These include:
Management Position - In many cases, a venture capital firm will want to add a
member of their team to the start up company's management team. This is generally
to ensure that the company can be successful, though this can also create internal
problems.
Equity Position - Most venture capital firms require that the company give up an
equity position to them in return for their funding. This amount is not small, in many
cases it can be as much as 60 percent of the equity in the company. In efect, this
means that the entrepreneur is not controlling their business; it is being controlled by
the venture capital firm.
Decision Making - One of the biggest problems that many entrepreneurs face when
they agree to accept venture capital is they often are giving up many key decisions in
how their company will operate. Venture capital firms that have taken an equity
position want a "seat at the table" when any major decision is made and they often
have the power to override decisions.
Business Plans - When a business plan is written and submitted for financing
considerations, most finance companies will agree to sign a non-disclosure
agreement. This is not the case in most venture capital firms. Venture capital firms
will nearly always refuse to sign a non-disclosure agreement due to the legal
ramifications of doing so. This can put ideas from an entrepreneur at risk.
Funding Plan - If an entrepreneur writes their business plan and determines they
need $500,000 to get the business launched, they may be lulled into thinking that
these funds will come up front. This is simply not the case. Venture capital firms
almost always set goals and milestones for releasing funds. Funding from venture
capital firms is typically done in stages with an eye on the expansion of the business.

These are only a few of the possible problems an entrepreneur could face when they
secure venture capital funding. It is important that they carefully review all
agreements and have them reviewed by an attorney as well.

Conclusion
If considering venture capital, the advantages and disadvantages are many. This type
of funding is not right for everyone. Those companies who have high growth potential
such as electronics manufacturers, green technologies, and other high tech ventures
are usually the ones who fare best with venture capital funding. Before you decide
that venture capital is right for you, make sure that you know all of the pros and cons
and do your research.

Resources
Sources:
Investopedia
1.
2.

3.

4.

Definition of Venture Capital:

http://www.investopedia.com/terms/v/venturecapital.asp
Kochanek, David; Top 9 Venture Capital Interview Questions
http://www.investopedia.com/articles/financial-careers/08/venture-capital-interviewquestions.asp
Beattie, Andrew; Georges Doriot And The Birth Of Venture Capital
http://www.investopedia.com/articles/financialcareers/10/georges-doriot-venturecapital.asp
Loiscono, CPA, Stephanie; Private Equity A Trendsetter For
Stockshttp://www.investopedia.com/articles/07/private-equity.asp

Image Credits:

Cash: Purchased Image via iStockPhoto/bobainsworth

Venture Capital Fund Diagram via Wikimedia Commons.org/Urbanrenewal
Public Domain

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2.
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History[edit]
A venture may be defined as a project prospective converted into a process with an
adequate assumed risk and investment. With few exceptions, private equity in the first half of

the 20th century was the domain of wealthy individuals and families. The Wallenbergs,
Vanderbilts, Whitneys, Rockefellers, and Warburgs were notable investors in private
companies in the first half of the century. In 1938, Laurance S. Rockefeller helped finance
the creation of both Eastern Air Lines and Douglas Aircraft, and the Rockefeller family had
vast holdings in a variety of companies. Eric M. Warburgfounded E.M. Warburg & Co. in
1938, which would ultimately become Warburg Pincus, with investments in bothleveraged
buyouts and venture capital. The Wallenberg family started Investor AB in 1916 in Sweden
and were early investors in several Swedish companies such as ABB, Atlas Copco, Ericsson,
etc. in the first half of the 20th century.

980s[edit]
The public successes of the venture capital industry in the 1970s and early 1980s
(e.g., Digital Equipment Corporation,Apple Inc., Genentech) gave rise to a major proliferation
of venture capital investment firms. From just a few dozen firms at the start of the decade,
there were over 650 firms by the end of the 1980s, each searching for the next major "home
run." The number of firms multiplied, and the capital managed by these firms increased from
$3 billion to $31 billion over the course of the decade. [17]
The growth of the industry was hampered by sharply declining returns, and certain venture
firms began posting losses for the first time. In addition to the increased competition among
firms, several other factors affected returns. The market for initial public offerings cooled in
the mid-1980s before collapsing after the stock market crash in 1987, and foreign
corporations, particularly from Japan and Korea, flooded early-stage companies with capital.
[17]

Characteristics of Venture
Capital Funding
more at http://www.citeman.com/672

Posted on May 15, 2012

by Manish
in CFA Exam, CFA Exam Level 1, Investment Management
Venture Capital Funding can be of different kinds. Early stage funding could be at the stage of ideation,
initial production and marketing. Expansion funding is done during commercial production, marketing and
growth (For more information refer to the article Stages of Venture Capital Funding). Different funds
focus on different types of funding and sectors. There are however some unifying characteristics
of venture capital funds.
Illiquidity: Easy liquidity by cashing out in the short-term is not an option for venture capital
funding. An IPO or buyout of a venture is how venture capitalists disinvest. A premature IPO
could undermine an otherwise successful company. Alternatively an IPO released in a poor IPO
market could also stall possibilities of cash out.

Long-term commitment: Venture capital funds need to be latched in for a period of few years
before disinvestment. Investors who do not prefer illiquidity will attach a premium to their funds,
also known as liquidity risk premium. Therefore an investor who can wait out the time horizon
will benefit from this premium. University endowments who seek VC funds to invest in are an
example of such investors.
Difficulty in determining current market values: It is difficult to evaluate the current market
value of the portfolio of a VC.
Limited historical risk and return data and limited information: Venture capital funds more
often than not invest in new and cutting edge industries of a sector, where there is little historical
data or continuous trading data. It is also difficult to estimate cash flows or the probability of
success.
Entrepreneurial/management mismatches: Entrepreneurs may face difficulties when there is
dilution of ownership and control. Bad management choices may scuttle a good venture.
Entrepreneurs sometimes find it difficult to step up as the venture gains size.
Fund manager incentive mismatches: Investors interested in well performing rather than large
sized funds need to find managers who match their investment objectives.
Knowledge of competition: As we discussed earlier since most business that are funded are from
nascent industries it is difficult to assess the competition, than say in established industries. A
complete competitive analysis is therefore difficult to undertake for a VC fund.
Vintage Cycles: Economic conditions vary from year to year. During some years venture capital
funding is plenty and therefore returns for them low. In poor or stressed market condition, even
good firms find it difficult to find VC funding.
Extensive Operation Analysis and Advice: Venture capital funds that plan to invest in
technology companies may not have the required expertise to assess them. Financial investment
knowledge alone is not sufficient. Good fund managers therefore require both operating and
financial analysis and advising skills. A fund manager who does not understand the business will
impede rather than improve it.

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Icici Venture Capital Fund

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