How Does A Venture Capital Firm Work?
While securing funding from a Venture Capital Firm (VCs) is the ultimate aim of a startup, and earns you a credible status in the world of banking and finance, there is very little that an average Joe knows about VCs. For starters, VCs are NOT a collection of wealthy individuals throwing money at startups (though wealthy individuals are a part of it).
Let’s get the clarity.
What is a Venture Capital Firm?
A venture capital firm is a firm that manages funds for high net worth individuals and invests them in high-risk business ventures. They usually provide seed money to small or early stage businesses starting up. Such businesses are normally too risky for traditional funders like banks and other financial institutions. Venture capital firms take that risk on the promise of a handsome reward in the future.
Source of funds
These firms get their funds from high net worth individuals who want to develop their wealth and don’t mind taking risks. In addition, other financial institutions and funds may invest a small percentage of their total corpus in these firms for some aggressive returns. Furthermore, VCs have their own earnings that are retained for future investments.
Betting on the right horse
The VC Partners are the decision makers who go through the business plan, analyze the potential and the future profit possibility, and then commit the funds to the business. Startup entrepreneurs consider this an acid test for their idea. If they get VC funding, it normally means that the seasoned and shrewd believe in their business idea. This is a big boost for them.
High risk, high return
Since the investments are normally risky, the venture capital firms normally charge a higher rate of interest to the enterprises it is funding. This high rate is justified, as these businesses do not get the funds through other sources. If the venture is successful, they reap a big profit on cashing out. But if the business crashes, they might lose 100% of it.
Money and more
VC firms don’t only provide start-up financing, but also offer extension financing, guidance, and most of all credibility. A business backed by a VC has a better chance of attracting quality talent, good vendors, and further funding.
The pay day
So far we have discussed, how they invest, now let’s see how they make money. While the funds charge their investors with a management fee (roughly 2% of the corpus), and a high-interest rate, the real money comes from the big ‘Pay Day’, when the business they invested in, goes public or is acquired by another firm. Unlike traditional investment vehicles, which give an assured return of 8-12%, the VCs can reap several times of their investment over a period of 3-10 years. Ever heard of Facebook? But, then there is a risk of losing the entire invested amount if the firm fails (and an overwhelming majority of them eventually fails).
The world needs them
While they are normally portrayed as greedy, evil people, the reality is quite different. They are the ones who keep the entrepreneurial spirit alive and kicking. They are the ones who make the wildest dreams turn real. They are the ones who made the Steve Jobs and the Binny Bansal of the world. And they did that at their own risk. Now, that’s capitalism at its best.
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