The term Venture Capital refers to investments by private investors in early stage companies. The capital is invested in the company’s infrastructure and balance sheet, and the VC will stay involved until the company reaches a certain level of credibility, size, and profit. Most venture capital funds last for up to 10 years, but some funds close early. Depending on the stage of the business and its goals, the amount of capital raised could be smaller or larger than the amount needed to get the business off the ground.
The capital markets structure of today’s market has created a unique niche for venture capital. The ERISA (Employee Retirement Income Security Act) prohibits banks from charging high interest rates on loans to new businesses. Because of this, many start-ups cannot access traditional financial institutions to raise their initial funding. However, in 1978 the US Labor Department relaxed the ERISA restrictions and began to provide a major source of funding for venture capitalists.
While venture capital has a purpose – to generate financial returns by supporting innovations – the approach has been fraught with criticism. The Employee Retirement Income Security Act, which prevents many risky investments, led to the largest bankruptcy in history and the collapse of Lehman Brothers due to a dodgy mortgage loan. While these examples may seem extreme, they are common in other areas of the economy and are growing at a rapid pace.
The early days of venture capital were marked by the growth of the technology industry. The first major fundraising year was in 1978, when the industry raised $750 million, which would be considered a record for the industry. The ERISA restrictions made many private company investments too risky for most corporate pension funds. After the advent of the Internet, the US Labor Department relaxed the rules and the first round of funding was secured by US corporate pension funds. In March 2000, the NASDAQ Composite Index reached a peak of 5,048, the highest in its history.
Although a small percentage of venture capitalists will invest in the early stages of a business, the initial stage of the process is crucial. Without the right capital, an early stage startup will not be able to grow and be profitable. The funds raised for this stage of a business’s development are crucial for a number of reasons, including the need to find a way to raise more money than needed. For instance, a new product may require a large marketing budget, and the company will need to hire a sales team.
A VC fund connects the two parties. It spends a lot of time vetting a startup company, and subsequently packages it for sale to limited partners. The VC also provides the entrepreneur with guidance and helps keep in contact with investment bankers for potential exits. While some venture capital funds require a large investment, angel investors tend to invest in smaller amounts. In addition to angel investors, VC firms also provide seed capital to businesses that need the financing to grow.