Venture capital investing is a type of private equity investing that involves investment in a business that requires capital. The business often requires capital for initial setup (or expansion). Venture capital investing may be done at an even earlier stage known as the “idea phase”. A venture capitalist may provide resources to an entrepreneur because the former believes that the latter can come up with a great business idea.
What is Venture Capital Investing?
Private equity investments are equity investments that are not traded on public exchanges (such as the New York Stock Exchange). Institutional and individual investors usually invest in private equity through limited partnership agreements, which allow investors to invest in a variety of venture capital projects while preserving limited liability (of the initial investment).
Venture capital investing projects are usually run by private equity funds with each PE fund running a portfolio of projects it specializes in. For instance, a private equity fund specializing in artificial intelligence may invest in a portfolio of ten venture capital projects on fully intelligent vehicles.
Stages of Venture Capital Investing
1. Seed-stage Capital
Seed-stage capital is the capital provided to help an entrepreneur (or prospective entrepreneur) develop an idea. Seed stage capital usually funds the research and development (R&D) of new products and services and research into prospective markets.
2. Early-stage Capital
Early-stage capital is venture capital investing provided to set up initial operation and basic production. Early stage capital supports product development, marketing, commercial manufacturing, and sales.
3. Later-stage Capital
Later-stage capital is the venture capital investing provided after the business generates revenues but before an Initial Public Offering (IPO). It includes capital needed for initial expansion (second-stage capital), capital needed for major expansions, product improvement, major marketing campaigns, mergers & acquisitions (third-stage capital), and capital needed to go public (mezzanine or bridge capital).
Characteristics of Venture Capital Investing
Venture capital investments are usually long-term investments and are fairly illiquid compared to market-traded investment instruments. Unlike, publicly traded investment instruments, VC investments don’t offer the option of a short-term payout. Long-term returns from venture capital investing depend largely on the success of an IPO.
2. Long-term investment horizon
Venture capital investments feature a structural time-lag between the initial investment and the final pay-out. The structural time-lag increases the liquidity risk. Therefore, VC investments tend to offer very high returns to compensate for this higher than normal liquidity risk.
3. Large discrepancy between private valuation and public valuation (market valuation)
Unlike standard investment instruments that are traded on some organized exchange, VC investments are held by private funds. Thus, there is no way for any individual investor in the market to determine the value of the investment. The venture capitalist also does not know how the market values his investment. This causes IPOs to be the subject of widespread speculation from both the buy-side and the sell-side.
4. Entrepreneurs lack full information about the market
The majority of venture capital investing is into innovative projects whose aim is to disrupt the market. Such projects offer potentially very high returns but also come with very high risks. As such, entrepreneurs and VC investors often work in the dark because no one else has done what they are trying to do.
5. Mismatch between entrepreneurs and VC investors
An entrepreneur and an investor may have very different objectives with regards to a project. The entrepreneur may be concerned with the process (i.e., the means) whereas the investor may only be concerned with the return (i.e., the end).
6. Mismatch between VC investors and fund managers
An investor and a fund manager may have different objectives regarding a particular project. The difference in interest depends largely on the contract signed by the fund manager. For instance, many fund managers are paid based on the size of the VC fund and not based on the returns generated. Such fund managers tend to take on excessive risk with regards to investments.