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What is venture capital?
Venture capital is a temporary quasi-equity or equity investment provided to small businesses and startup firms that are expected to have long-term growth. Conventional investments in companies are done through the stock market, with the firms receiving the finances via shareholders. But for startups and small businesses that do not have access to capital markets, venture capital becomes an essential source of financing.
One of the main features of this type of investment is the high risk. Most venture capital investments are done with companies and industrial sectors that are new and thus do not have any historical and return data. It is difficult to estimate the probability of success of such companies. Lack of information about startups also makes it hard to evaluate their current market value.
The business owners also have risks. They may lose control of their business, with the investors ending up owning the company or having a say in crucial decisions.
To minimize the risks of the investment, venture capital institutions make sure that they properly appraise the startup company before lending it money. The appraisal is usually similar to the project appraisals that commercial banks do before lending money.
There are different stages to the venture capital funding of an organization. These are:
- The seed stage. Funds invested at this stage are used for market research and product development.
- The early stage is the funding of operations that precede commercial production.
- The formative funding stage is the financing of the early and seed stage funding.
- Later stage funding is the funding given before an initial public offering, or IPO.
Venture capital funding is usually a long-term commitment. The venture capital funds are generally supposed to be held for a couple of years. For this reason, venture capital funding does not typically give investors an option to cash out on a short-term basis. Financiers can disinvest from a venture only by buying out, or through IPOs.
Another common characteristic of this form of capital is that the finances provided by the investors are usually in the form of inconvertible debentures or loans so as to ensure that they have a fixed yield.
Example of venture capital
One of the greatest advantages of capital financing is that it promotes viable business ideas and entrepreneurs. The majority of businesses based on original ideas are started by firms that have no funding to push their projects to the next level. However, through venture capital financing, entrepreneurs are given the chance to bring their ideas to fruition.
By promoting startups and small companies, venture capital institutions promote self-employment and thus help reduce unemployment rates. Supporting startups means supporting invention and innovation. Therefore, venture capital institutions play an important role in keeping the markets alive and competitive by supporting new products and companies.