By Jay Jia. Edited By Aniket Bose and Swastik Patel.
From the perspective of investment behavior, venture capital (VC) is a form of investment in the research and development field of startups, early stage and emerging companies that have a high risk of failure but high potential. VC aims to promote the commercialization and industrialization of the company as soon as possible, in order to obtain high capital returns. This article will take a deeper dive into the meaning and importance of VC.
The Investment Process
The operation of VC includes four main stages: financing, investment, management and exit.
The financing phase addresses the question of “where does the money come from”. Usually, sources of venture capital include pension funds, insurance companies, commercial banks, investment banks, large companies, university endowments, wealthy individuals and organizations, just to name a few. In the financing stage, the most important issue is solving the investor’s rights and obligations along with the arrangement of the distribution of interests.
The investing phase addresses the question of “where does the money go”. Professional venture capital institutions invest venture capital to start-up companies with huge growth potential through a series of procedures such as preliminary project screening, due diligence, valuation, negotiation, term design, and investment structure arrangement.
The management stage solves the problem of “value added”. Venture capital institutions focus on value appreciation by conducting supervision and service regulations. “Supervision” mainly includes means of participating in the board of directors of the invested company and replacing management team members when the performance of the company does not reach the expected target. “Service” mainly includes helping the invested company in different ways, by improving business plans, corporate governance structures, and helping investee companies obtain follow-up financing. Value-added management is an important aspect that differentiates venture capital from other investments.
The exit phase addresses the question of “how the benefits are realized”. Venture capital institutions withdraw from their invested start-up enterprises through IPO (Initial Public Offering), equity transfer and bankruptcy liquidation to realize investment income. After the exit is completed, the venture capital institution also needs to distribute the investment income to the investors who provide the venture capital to the company.
Venture capital generally operates in the form of venture capital funds. The legal structure of a venture capital fund is to take the form of a limited partnership, while the venture capital firm manages the fund’s investment operations as a general partner and gets paid accordingly.Venture capital funds that adopt a limited partnership system in the United States can obtain tax benefits, and the government also encourages the development of venture capital to function in this manner.
Who to Invest?
Most of the investment targets for venture capitalist firms are small and medium-sized enterprises in the start-up period, with the majority of them being high-tech enterprises. VC firms tend to invest in them for a period of 3-5 years and generally raise the equity of the invested company by 30%. Venture capitalists participate in the operation and management of the invested enterprises and provide value-added services for the company.
Since the purpose of investment is to pursue excess returns, when the invested company adds value, venture capitalists will withdraw their capital through listing, mergers and acquisitions or other equity transfer methods to achieve value-added.
In conclusion, VC is a form of financing that sees the potential in small and developing companies, in which they provide funding, supervision, and value-added services, with the ultimate goal of obtaining high returns on their investments, along with a high risk of failure.