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Venture Capital Alternative

Updated on October 26, 2011

History of Venture Capital

Venture capital (VC) is financial capital provided to early-stage, high-potential, growth Startup companies. The venture capital fund makes money by owning equity in the companies it has interest in. These companies should always have a strong business plan or model.

With few exceptions, private equity in the first half of the 20th century was controlled by wealthy individuals and families. The Vanderbilts, Whitneys, Rockefellers, and Warburgs were notable investors in private companies in the first half of the century.

Venture Capital

Venture Capital is attractive for new companies with limited operating history that are too small to raise capital in the public markets and have not reached the point where they are able to secure any form of banking loans or complete a debt offering. In exchange for the high risk that venture capitalists assume by investing in smaller and less mature companies, venture capitalists usually get significant control over company decisions, in addition to a significant portion of the company's ownership.

Venture capitalists are typically very selective in deciding what to invest in. Funds are most interested in ventures with exceptionally high growth potential, as only such opportunities are likely capable of providing the financial returns and successful exit event within the required timeframe (typically 2–7 years) that venture capitalists expect.

Young companies wishing to raise venture capital require a combination of extremely rare, yet sought after, qualities, such as innovative technology, potential for rapid growth, a well-developed business plan, and an impressive management team.

Because investments are illiquid and require 2–7 years to harvest, venture capitalists are expected to carry out detailed due diligence prior to investment. Venture capitalists also are expected to nurture the companies in which they invest.

A venture capitalist (also known as a VC) is a person or investment firm that makes venture investments, and these venture capitalists are expected to bring managerial and technical expertise as well as capital to their investments. .

A core skill within VC is the ability to identify novel technologies that have the potential to generate high commercial returns at an early stage. By definition, VCs also take a role in managing entrepreneurial companies at an early stage, thus adding skills as well as capital (thereby differentiating VC from buy-out private equity, which typically invest in companies with proven revenue), and thereby potentially realizing much higher rates of returns.

Inherent in realizing abnormally high rates of returns is the risk of losing all of one's investment in a given startup company. As a consequence, most venture capital investments are done in a pool format, where several investors combine their investments into one large fund that is used to create funding in many different startup companies. By investing in the pool format, the investors are spreading out their risk to many different investments versus taking the chance of putting all of their money in one start up firm.

Venture capital firms are typically structured as partnerships, the general partners of which serve as the managers of the firm and will serve as investment advisors to the venture capital funds raised. Venture capital firms in the United Kingdom may also be structured as limited liability companies, in which case the firm's managers are known as managing members. Investors in venture capital funds are known as limited partners.

This constituency comprises both high net worth individuals and institutions with large amounts of available capital, such as state and private pension funds, university financial endowments, foundations, insurance companies, and pooled investment vehicles, called fund of funds or mutual funds.

How to Obtain Venture Capital Alternative

Venture capital firms will approach each individual business differently

For instance, if you're a startup internet company, funding requests from a more manufacturing-focused firm will not be effective. Doing some initial research on which firms to approach will save time and effort. When approaching a VC firm, consider their portfolio:

Business Cycle: Do they invest in budding or established businesses?
Industry: What is their industry focus?
Investment: Is their typical investment sufficient for your needs?
Location: Are they regional, national or international?
Return: What is their expected return on investment?
Involvement: What is their involvement level?

In structuring its investment, the venture capitalist may use one or more of the following types of share capital:

Ordinary shares
These are equity shares that are entitled to all income and capital after the rights of all other classes of capital and creditors have been satisfied. Ordinary shares have votes. In a venture capital deal these are the shares typically held by the management and family shareholders rather than the venture capital firm.

Preferred ordinary shares
These are equity shares with special rights.For example, they may be entitled to a fixed dividend or share of the profits. Preferred ordinary shares have votes.

Preference shares
These are non-equity shares. They rank ahead of all classes of ordinary shares for both income and capital. Their income rights are defined and they are usually entitled to a fixed dividend (eg. 10% fixed). The shares may be redeemable on fixed dates or they may be irredeemable. Sometimes they may be redeemable at a fixed premium (eg. at 120% of cost). They may be convertible into a class of ordinary shares.

Loan capital
Venture capital loans typically are entitled to interest and are usually, though not necessarily repayable. Loans may be secured on the company's assets or may be unsecured. A loan that is secured will rank ahead of unsecured loans and certain other creditors of the company. A loan may be convertible into equity shares. Alternatively, it may have a warrant attached which gives the loan holder the option to subscribe for new equity shares on terms fixed in the warrant. They typically carry a higher rate of interest than bank term loans and rank behind the bank for payment of interest and repayment of capital.

Venture capital investments are often accompanied by additional financing at the point of investment. This is nearly always the case where the business in which the investment is being made is relatively mature or well-established. In this case, it is appropriate for a business to have a financing structure that includes both equity and debt.

Other forms of finance provided in addition to venture capitalist equity include

Clearing banks - principally provide overdrafts and short to medium-term loans at fixed or, more usually, variable rates of interest.

Merchant banks - organise the provision of medium to longer-term loans, usually for larger amounts than clearing banks. Later they can play an important role in the process of "going public" by advising on the terms and price of public issues and by arranging underwriting when necessary.

Finance houses - provide various forms of installment credit, ranging from hire purchase to leasing, often asset based and usually for a fixed term and at with the interest usually fixed rated.

Factoring companies - provide finance by buying trade debts at a discount, either on a recourse basis (you retain the credit risk on the debts) or on a non-recourse basis (the factoring company takes over the credit risk).

Government and European Commission sources - set up to supply financial capital and aid to UK companies, ranging from project grants (related to jobs created and safeguarded) to enterprise loans in selective areas.

Mezzanine firms - provide loan finance that is halfway between equity and secured debt. These facilities require either a second charge on the company's assets or are unsecured. Because the risk is consequently higher than senior debt, the interest charged by the mezzanine debt provider will be higher than that from the principal lenders and sometimes a modest equity "up-side" will be required through options or warrants. It is generally most appropriate for larger transactions.


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