Venture Capital (Encyclopedia of Management)
Venture capital refers to money that is invested in companies during the early stages of their development. Such funds may come from wealthy individuals, government-backed Small Business Investment Companies (SBICs), or professionally managed venture capital firms. Since investing in an unproven business venture is highly speculative, venture capitalists generally target companies that they believe offer significant potential for growth, and therefore an opportunity to earn a high rate of return in a relatively short period of time. In exchange for providing capital, as well as a source of management assistance and industry contacts for growing firms, the investors usually require a percentage of equity ownership in the company, some measure of control over its strategic direction, and payment of assorted fees. "Private equity provides capital and access to a network that can transform a company into an industry player," Karen E. Klein noted in Business Week. "But the price is high: a chunk of your business."
Like other sources of equity financing, venture capital offers both advantages and disadvantages. The main advantage is that the business is not obligated to repay the money. For a start-up company, this frees up important cash flow that might otherwise be needed to service debt. The involvement of high-profile investors may also help increase the credibility of a new business. The main disadvantage to venture capital financing is that the investors become part owners of the business, and thus gain a say in business decisions. The company's founders face a dilution of their ownership positions and a possible loss of autonomy or control.
Even for business owners willing to make the tradeoff, venture capital is scarce and often difficult to obtain. Venture capitalists tend to be highly selective in choosing investments. Some will only consider investments in specific technologies, industries, or geographic areas. In fact, the larger venture capital firms typically reject more than 90 percent of the requests for funding that they receive. They evaluate the remaining requests thoroughly, and at considerable expense, before selecting a few that closely match the investors' areas of expertise and offer the best earnings potential. As a result, private equity financing is more likely to be an option for existing businesses with a solid track record and good prospects for future growth than for start-up companies. It is a particularly good choice for fast-growing companies that have few tangible assets to use as collateral for loans.
For a business owner, the process of obtaining venture capital begins with a formal proposal. The most important element of this proposal is a detailed business plan describing the company's goals and strategies. The proposal should also include recent financial statements, projections of future growth, a brief history of the company, biographies of key managers, the amount of money requested, and a description of how the funds will be used. Experts recommend that companies seeking equity financing evaluate several venture capital firms before entering into a deal. Managers should also hire professionals to help them understand the terms of the agreement to avoid giving away too much control.
On receiving a proposal of interest, a venture capital firm usually follows up with a thorough investigation of the company's investment potential. This process might include analyzing financial statements, interviewing customers and suppliers, and meeting with the management team. If the venture capital firm remains interested following the evaluation phase, it usually responds with a proposal of its own, known as a term sheet. The term sheet acts as a blueprint for the investment deal, with provisions covering such issues as the valuation of the investment, voting rights, and liquidation options.
The final terms are decided through negotiations between the business managers and the venture capital firm. One of the most important factors in the negotiation process is agreeing upon the valuation of the business, which determines the amount of equity that is required in exchange for the venture capital (a business with a low valuation must provide a high percentage of equity, and vice versa). As a general rule, venture capital firms seek to control between 30 and 40 percent of equity in the companies in which they invest. This amount allows the venture capital firm to exercise influence without assuming control or eliminating the management team's incentive to grow the business. The venture capital firm usually hopes to achieve a return of three to five times the original investment within five years, by selling its equity either to the company's management or on the public stock markets.
Overall, venture capital can provide a valuable source of financing for growing businesses. Because of its associated risks, however, experts generally suggest that it be viewed as one of a number of potential sources of financing and be used in combination with debt financing whenever possible. "Private equity isn't for the faint of heart," Klein acknowledged. "But then again, entrepreneurs aren't known for being timid."
Bartlett, Joseph W. Fundamentals of Venture Capital. Lanham, MD: Madison Books, 1999.
Cardis, Joe, et al. Venture Capital: The Definitive Guide for Entrepreneurs, Investors, and Practitioners. New York: Wiley & Sons, 2001.
Klein, Karen E. "A Private Equity Affair: Getting the Most from Venture Capital." Business Week, 1 November 2004, 47.
McKimmie, Kathy. "Funding Fundamentals: Where to Turn for Startup and Expansion Capital." Indiana Business Magazine, January 2004, 247.
Stancill, James McNeill. Entrepreneurial Finance: For New and Emerging Businesses. Mason, OH: Thomson/South-Western, 2004.
Weiss, Jeffrey M. "Venture Capital Tips." Detroiter, May 2002, 19.
Worrell, David. "Raising Money: All in the Delivery." Entrepreneur, May 2004.
Venture Capital (Encyclopedia of Small Business)
Venture capital refers to funds that are invested in an unproven business venture. Venture capital may be provided by wealthy individual investors, professionally managed investment funds, government backed Small Business Investment Corporations (SBICs), or subsidiaries of investment banking firms, insurance companies, or corporations. Such venture capital organizations generally invest in private startup companies with a high profit potential. In exchange for their funds, venture capital organizations usually require a percentage of equity ownership of the company, some measure of control over its strategic planning, and payment of assorted fees. Due to the highly speculative nature of their investments, venture capital organizations expect a high rate of return. In addition, they often wish to obtain this return over a relatively short period of time, usually within three to seven years. After this time, the equity is either sold back to the client company or offered on a public stock exchange.
Venture capital is somewhat more difficult for a small business to obtain than other sources of financing, such as bank loans and supplier credit. Before providing venture capital to a new or growing business, venture capital organizations require a formal proposal and conduct a thorough evaluation. Even then, they tend to approve only a small percentage of the proposals they receive. Perhaps the most important thing an entrepreneur can do to increase his or her chances of obtaining venture capital is to plan ahead.
Venture capital offers several advantages to small businesses, including management assistance and lower costs over the short term. In addition, venture capital is more likely to be available to startup or concept businesses than other forms of financing. The disadvantages associated with venture capital include the possible loss of effective control over the business and relatively high costs over the long term. Overall, experts suggest that entrepreneurs should consider venture capital to be one financing strategy among many, and should seek to combine it with debt financing if possible.
THE EVALUATION PROCESS
Since it is often difficult to evaluate the earnings potential of new business ideas or very young companies, and investments in such companies are unprotected against business failures, venture capital is a highly risky industry. As a result, venture capital firms set rigorous policies and requirements for the types of proposals they will even consider. Some venture capitalists specialize in certain technologies, industries, or geographic areas, for example, while others require a certain size of investment. The maturity of the company may also be a factor. While most venture capital firms require their client companies to have some operating history, a small number handle startup financing for businesses that have a well-considered plan and an experienced management group.
In general, venture capitalists are most interested in supporting companies with low current valuations, but with good opportunities to achieve future profits in the range of 30 percent annually. Most attractive are innovative companies in rapidly accelerating industries with few competitors. Ideally, the company and its product or service will have some unique, marketable feature to distinguish it from imitators. Most venture capital firms look for investment opportunities in the $250,000 to $2 million range, although some are willing to consider smaller or larger projects. Since venture capitalists become part owners of the companies in which they invest, they tend to look for businesses that can increase sales and generate strong profits with the help of a capital infusion. Because of the risk involved, they hope to obtain a return of three to five times their initial investment within five years.
Venture capital organizations typically reject the vast majority0 percent or moref proposals quickly because they are deemed a poor fit with the firm's priorities and policies. They then investigate the remaining 10 percent of the proposals very carefully and at considerable expense. Whereas banks tend to focus on companies' past performance when evaluating them for loans, venture capital firms tend to focus instead on their future potential. As a result, venture capital organizations will examine the features of a small business's product, the size of its markets, and its projected earnings.
As part of the detailed investigation, a venture capital organization may hire consultants to evaluate highly technical products. They also may contact a company's customers and suppliers in order to obtain information about the market size and the company's competitive position. Many venture capitalists will also hire an auditor to confirm the financial position of the company, and an attorney to check the legal form and registration of the business. Perhaps the most important factor in a venture capital organization's evaluation of a small business as a potential investment is the background and competence of the small business's management. Hosmer noted that "many venture capital firms really invest in management capability" rather than a small business's product or market potential. Since the abilities of management are often difficult to assess, it is likely that a representative of the venture capital organization would spend a week or two at the company. Ideally, venture capitalists like to see a committed management team with experience in the industry. Another plus is a complete management group with clearly defined responsibilities in specific functional areas, such as product design, marketing, and finance.
VENTURE CAPITAL PROPOSALS
In order to best ensure that a proposal will be seriously considered by venture capital organizations, an entrepreneur should furnish several basic elements. After beginning with a statement of purpose and objectives, the proposal should outline the financing arrangements requested, i.e., how much money the small business needs, how the money will be used, and how the financing will be structured. The next section should feature the small business's marketing plans, from the characteristics of the market and the competition to specific plans for getting and keeping market share.
A good venture capital proposal will also include a history of the company, its major products and services, its banking relationships and financial milestones, and its hiring practices and employee relations. In addition, the proposal should include complete financial statements for the previous few years, as well as pro forma projections for the next three to five years. The financial information should detail the small business's capitalization.e., provide a list of shareholders and bank loansnd show the effect of the proposed project on its capital structure. The proposal should also include biographies of the key players involved with the small business, as well as contact information for its principal suppliers and customers. Finally, the entrepreneur should outline the advantages of the proposalncluding any special and unique features it may offers well as any problems that are anticipated.
If, after careful investigation and analysis, a venture capital organization should decide to invest in a small business, it then prepares its own proposal. The venture capital firm's proposal would detail how much money it would provide, the amount of stock it would expect the small business to surrender in exchange, and the protective covenants it would require as part of the agreement. The venture capital organization's proposal is presented to the management of the small business, and then a final agreement is negotiated between the two parties. Principal areas of negotiation include valuation, ownership, control, annual charges, and final objectives.
The valuation of the small business and the entrepreneur's stake in it is very important, as it determines the amount of equity that is required in exchange for the venture capital. When the present financial value of the entrepreneur's contribution is relatively low compared to that made by the venture capitalistsor example, when it consists only of an idea for a new producthen a large percentage of equity is generally required. On the other hand, when the valuation of a small business is relatively highor example, when it is already a successful companyhen a small percentage of equity is generally required. Hosmer warns that entrepreneurs are likely to find that the valuation of their businesses provided by a venture capital organization will not be as high as they would like.
The percentage of equity ownership required by a venture capital firm can range from 10 percent to 80 percent, depending on the amount of capital provided and the anticipated return. But most venture capital organizations want to secure equity in the 30-40 percent range so that the small business owners still have an incentive to grow the business. Since venture capital is in effect an investment in a small business's management team, the venture capitalists usually want to leave management with some control. In general, venture capital organizations have little or no interest in assuming day-to-day operational control of the small businesses in which they invest. They have neither the technical expertise or managerial personnel to do so. But venture capitalists usually do want to place a representative on each small business's board of directors in order to participate in strategic decision-making.
Many venture capital agreements include an annual charge, typically 2-3 percent of the amount of capital provided, although some firms instead opt to take a cut of profits above a certain level. Venture capital organizations also frequently include protective covenants in their agreements. These covenants usually give the venture capitalists the ability to appoint new officers and assume control of the small business in case of severe financial, operating, or marketing problems. Such control is intended to enable the venture capital organization to recover some of its investment if the small business should fail.
The final objectives of a venture capital agreement relate to the means and time frame in which the venture capitalists will earn a return on their investment. In most cases, the return takes the form of capital gains earned when the venture capital organization sells its equity holdings back to the small business or on a public stock exchange. Another option is for the venture capital firm to arrange for the small business to merge with a larger company. The majority of venture capital arrangements include an equity position, along with a final objective that involves the venture capitalist selling that position. For this reason, entrepreneurs considering using venture capital as a source of financing need to consider the impact a future stock sale will have on their own holdings and their personal ambition to run the company. Ideally, the entrepreneur and the venture capital organization can reach an agreement that will help the small business grow enough to provide the venture capitalists with a good return on their investment as well as to overcome the owner's loss of equity.
THE IMPORTANCE OF PLANNING
Although there is no way for a small business to guarantee that it will be able to obtain venture capital, sound planning can at least improve the chances that its proposal will receive due consideration from a venture capital organization. Such planning should begin at least a year before the entrepreneur first seeks financing. At this point, it is important to do market research to determine the need for a new business concept or product idea and establish patent or trade secret protection, if possible. In addition, the entrepreneur should take steps to form a business around the product or concept, enlisting the assistance of third-party professionals like attorneys, accountants, and financial advisors as needed.
Six months prior to seeking venture capital, the entrepreneur should prepare a detailed business plan, complete with financial projections, and begin working on a formal request for funds. Three months in advance, the entrepreneur should investigate venture capital organizations to identify those that are most likely to be interested in the proposal and to provide a suitable venture capital agreement. The best investor candidates will closely match the company's development stage, size, industry, and financing needs. It is also important to gather information about a venture capitalist's reputation, track record in the industry, and liquidity to ensure a productive working relationship.
One of the most important steps in the planning process is preparing detailed financial plans. Hosmer claimed that strong financial planning demonstrates managerial competence and suggests an advantage to potential investors. A financial plan should include cash budgetsrepared monthly and projected for a year aheadhat enable the company to anticipate fluctuations in short-term cash levels and the need for short-term borrowing. A financial plan should also include pro forma income statements and balance sheets projected for up to three years ahead. By showing expected sales revenues and expenses, assets and liabilities, these statements help the company to anticipate financial results and plan for intermediate-term financing needs. Finally, the financial plan should include an analysis of capital investments made by the company in products, processes, or markets, along with a study of the company's sources of capital. These plans, prepared for five years ahead, assist the company in anticipating the financial consequences of strategic shifts and in planning for long-term financing needs.
Overall, experts warn that it takes time and persistence for entrepreneurs to obtain venture capital. But venture capital is becoming more widely available than ever before because of the strong American economy, rising trends of private investment, and the rapid emergence of new technology in areas such as the Internet, telecommunications, and health care. Finally, another trend in the industry involves foreign venture capital. Under this arrangement, overseas companies provide financing to small U.S. firms in exchange for royalties, a percentage of profits, a license for technology, or overseas sales agreements. Basically, these foreign companies try to form strategic partnerships with young American companies that are producing things needed in overseas markets.
Bartlett, Joseph W. Fundamentals of Venture Capital. Madison, 1999.
Clark, Scott. "Business Plan Basics: Who Most New Ventures Fail to Raise Capital." Houston Business Journal. March 17,2000.
Evanson, David R. "Venture Capital, Networks Proliferate." Nation's Business. September 1996.
Geer, John F., Jr. "The Venture Capital Boom: It's Gold Medal Time for the Venture Capitalists." Financial World. November 18, 1996.
Hamilton, Brian. Financing for the Small Business. Washington, D.C.: U.S. Small Business Administration, 1990.
Hosmer, LaRue T. A Venture Capital Primer for Small Business. Washington, D.C.: U.S. Small Business Administration, 1990.
Parmar, Simon, J. Kevin Bright, and E. F. Peter Newson. "Building a Winning E-Business." Ivey Business Journal. November 2000.
Schilit, W. Keith. The Entrepreneur's Guide to Preparing a Winning Business Plan and Raising Venture Capital. Prentice Hall, 1990.
Taylor, Charlotte. "Cash from Investors." Executive Female. July-August 1997.
SEE ALSO: Angel Investors
Venture Capital (Encyclopedia of Business)
The term "venture capital" (VC) usually refers to third-party private equity capital for new and emerging enterprises. Companies that specialize in providing this funding are known as venture capital firms or simply venture capitalists. In practice, venture capital firms often provide the entrepreneur with more than just money; since they usually become part owners in the firm, they frequently take an active role in shaping the company's business strategy and its managementncluding possibly installing one or more experienced executives from the outside.
While the venture capital firm may be affiliated with banks or other lending institutions, most are independent and privately managed. Their efforts are focused; business activity is limited to working with start-ups or young organizations. Venture capital organizations provide their clients with capital through direct equity investments, loans, or other financial arrangements. Due to the highly speculative nature of their investments, venture capitalists take big risks by working with new ventures. Indeed, the majority of companies they finance don't pan out. In exchange for the high level of risk, venture capitalists expect a high return on their investments from the few that do turn into successful enterprises.
FORMATION OF VENTURE CAPITAL FIRMS
All businesses need some financial resources to begin activity. The exchange between someone with a good idea (an entrepreneur) and someone with the resources to help make a business out of the idea (a banker, a rich uncle, or a venture capitalist) is as old as business itself. However, venture capital as a distinct form of business financing arose only recently. John Wilson, in his book The New Ventures, Inside the High Stakes World of Venture Capital, marks 1946 as the year the venture capital industry originated in the United States. J.H. Whitney brought together partners from the East Coast for the first venture capital fund, working with an initial capitalization of approximately $10 million. The structure of the first fund partnership between those contributing to the initial capitalizationas the model for a majority of venture capital organizations that followed as the industry grew.
One of the first venture capital funds was created by city leaders in Boston. The American Research and Development Corporation was headed by General George Doriot, one of the early leaders in the industry. The successful investments made by this group helped to legitimize the new form of financing. Burill and Norback, in their book The Arthur Young Guide to Raising Venture Capital argue that Doriot's leadership set the course for future venture capital organizations. "Doriotis famous for instituting the ethos of the venture capital industryhe venture capitalist as one who guides and manages a growing company through times thick and thin." ADR, and Doriot, gained attention because of the success of one of their first clients, Digital Equipment Corp. (DEC). The American Research and Development Corporation's initial investment of $67,000 grew into more than $600 million.
The passage of the Small Business Investment Act of 1958 by the federal government was an important incentive for would-be venture capital organizations. The act provided venture capital firms organized as Small Business Investment Companies (SBICs) and Minority Enterprise Small Business Investment Companies (MESBICs) with an opportunity to increase the amount of funds available to entrepreneurs. The privately managed SBICs and MESBICs had access to federal money through the Small Business Administration which could then be leveraged four dollars to one against privately raised funds. The SBICs and MESBICs, in turn, made the financial resources available to new ventures and entrepreneurs in their communities.
In recent decades, the venture capital industry has become big business. According to a widely cited annual estimate published by VentureOne Corporation, venture capital firms in 1998 disbursed approximately $12.5 billion in funds to approximately 1,800 new or continuing ventures. This level of funding was nearly double that just three years earlier. Part of the trend has been to invest more money in the typical new venture: the average size of investment in 1998 was approximately $6.8 million, compared with $5.4 million per deal as of 1995. These figures don't include so-called angel investors and venture capital provided by sources outside the mainstream venture capital industry, such as when large corporations provide equity funding to small strategic business partners.
As more capital has entered the VC arena, the focus of venture capital firms has also gradually shifted. Whereas the first venture capitalists provided money to organizations for very basic initial start-up activities, the industry increasingly looks for firms that are somewhat further along in their development. As a result, there is a tendency for venture capital organizations to shy away from early stage and startup financing. Rather than provide the entrepreneur or new venture with money early on in the growth of the business (in the first year of business, for instance), venture capital firms increasingly provide funds for products and services with proven markets and a higher chance of success in the marketplace.
What may have started out as a relatively loose partnership of individuals with money to invest has become a set of organizations with formalized structures and business activities. Venture capital firms, or financial firms that offer venture funds along with other financing options, have become accepted parts of the business world, finding their own niche as providers of capital for higher risk situations.
As the industry matures, two types of organizations predominate those disbursing venture capital. The structure of the venture organization usually dictates the means through which the organization makes a profit. Leveraged firms borrow money from other financial institutions, the government or private sources and, in turn, lend the funds to entrepreneurs and new ventures at a higher rate of interest. Leveraged firms make money by charging their clients a higher interest rate than they pay for the use of the funds. Because leveraged firms rely on interest income, they make most of the disbursements in the form of loans to new ventures. This practice is less common among firms that are dedicated to providing venture capital.
Equity firms sell stock in the venture capital organization to individual or institutional investors, in effect pooling investors' money, and then use the proceeds to purchase equity in new ventures. Equity venture capital firms build portfolios of investments in companies. This kind of venture capital company tries to resell the stock of its portfolio businesses at a later date for a profit. Whereas a leveraged firm can expect a relatively steady stream of interest income, an equity firm may not experience a return on their investment for years. The return usually comes as a result of the sale of their equity in the new venture. Venture capital organizations can either sell their equity back to the company itself or on the public stock exchanges (like the New York Stock Exchange) in an initial public offering (IPO).
There are a variety of ownership structures for venture capital firms. A few firms are publicly traded on the stock exchanges. Because of the nature of the ownership, these firms tend to be larger than most venture capital organizations. However, the overwhelming majority of firms are private companies. The firms may have been formed by individuals, families, or small groups of investors. Some are also limited partnerships formed by insurance companies or pension funds. These organizations generally form the venture capital organizations to achieve a greater rate of return than most of their other investments. Other firms are organized as bank subsidiaries as a way for the banks to own equity in small businesses. These organizations are independent of other bank activities. Some firms have been set up by corporations, although these are relatively rare. In other cases, corporations looking to gain high returns on their funds invest in existing venture capital limited partnerships where risk can be shared and liabilities are limited.
FORMS OF VENTURE CAPITAL FINANCING
Venture capital firms invest at different stages in the development of the enterprise, often according to their own particular investment strategy. The managers of a venture capital firm may prefer to invest in brand new companies or their strategy may dictate investment in businesses that are much more developed. Because the business is unproven, early investments are inherently more risky and the firm can demand a higher return. Later investments are more stable and bring a more modest return. Most venture capital firms try to diversify their holdings by investing in a variety of enterprises at various stages of development.
"Seed capital" is given to individuals or groups in the idea stage, the point at which there is a good idea for a business but no formal organization. At this stage, the entrepreneur is likely to use the money provided by a venture capital organization to conduct further market research, assemble a management team, or develop a prototype.
More often than not, those who look for seed capital are turned down by venture firms and must rely on their own resources to find the needed capital. However, after they have developed a prototype and proved their idea will be viable, new enterprises may approach a venture capital in order to gather funds needed to begin operations. In such cases, venture capital organizations provide "start-up" or "first-round" financing to give the growing business sufficient capital to meet the demands of defining and developing customer base and creating solid relationships with suppliers. First-round financing usually comes in the form of an equity investment. Venture firms will expect a higher rate of return for first-round investments.
As a new venture prospers, it may require additional financing to meet the capital needs inherent in expansion. Venture firms can provide second-round or "expansion-round" financing to their clients whose markets or sales are growing at such a rate that potential for profit looks good. At this point, the venture is usually heading towards success. Assuming the venture's early sales or sales commitments and general market prospects still appear strong, those seeking expansion financing are in a better bargaining position than those seeking first-round or seed money.
If the expansion stage is successful, the new venture may begin a period of fast growth. At this point, the company may be making money, but not enough to finance the rapid expansion. Additional "growth stage" or third-round capital may be solicited from venture capital firms. In other cases, the new venture may consider "going public," or offering equity on the public markets as a means of gaining a cash infusion.
In addition to financing different stages of growth, venture capital firms can be of service to entrepreneurs in other, related situations. Some venture firms will assist management in a merger, acquisition, or other form of buyout, where the stock of a company is purchased by a management team or a group of other entrepreneurs with the help and financial support of the venture capital firm's managers. In such a case, the money used to purchase the business is loaned to the buyout team by the venture capital firm. Another area of activity for some venture capital firms is "turnaround financing" for businesses that have suffered serious setbacks or are nearing bankruptcy. Funds provided by a venture capital firm are used to finance recovery efforts or launch new programs aimed at turning the business around. Although few firms undertake the risk inherent in financing a turnaround situation, most are willing to consider them as part of their business strategy.
THE SCREENING PROCESS
Competition for venture capitalists' limited funds is extremely intense, and often less than I percent of companies that solicit funds actually receive any. Generally only firms with significant growth potential are considered, and thus venture capital is not an option for small, individual-based businesses with less ambitious plans. A typical recipient of venture capital will expect sales in the tens of millions of dollars within the first couple years of their product or service reaching the market, and much larger long-term potential.
Other factors that influence the investment decision include:
- the venture capital firm's confidence in the business management
- how clearly and concisely the business proposition is presented
- the nature of the business and its intended market
- how quickly the company is likely to begin making sales, and especially, profits
- what other individuals or companies are backing the new venture
- personal referrals on the management or business in general
The screening process usually begins formally when the business seeking capital submits a business plan to the venture capital firm, although in practice often there is some form of interpersonal networking leading up to the submission, such as by word of mouth among mutual friends or business associates. Often, start-up firms enlist the support of experienced and well-placed attorneys or accountants who have worked with venture capitalists in the past. Indeed, there are law firms that specialize in this sort of practice. At the very least, usually the head of the start-up firm makes personal contact with a decision maker at the venture capital company via a phone call around the time the plan is submitted.
Venture capitalists scrutinize the business plan and the company submitting it thoroughly before proceeding any further. The venture capital firm must be confident that the claims made by the entrepreneur are realistic and attainable in general, and that the particular company and management team at hand is capable of pulling it off. In both the plan and any subsequent meetings, the venture capitalist attempts to size up the management's clarity of purpose, ability to cope with adversity, and market focus, among other things.
The venture capital firm must also have confidence the investment will pay out according to the plans offered by the entrepreneur. Before a venture capital firm makes an investment, it thoroughly investigates the client and the client's business in a process called due diligence. Due diligence simply means extensive research into the industry, the entrepreneur's background and experience, and the reliability of the financial projections supplied by the client. In addition, the due diligence process may include a visit to the client's place of business or questions about the client's personal and professional history. By conducting research into the client, the venture capital firm tries to maximize its understanding of the opportunity and its potential risks and rewards. By accumulating information, the venture capital firm better prepares itself to make the best possible decision about the investment.
After the venture capital firm is confident in the abilities and claims of the entrepreneur, it must be certain that it understands the market in which the new venture will operate. The experience and specialties of the firm's management will dictate whether or not the firm will narrow the focus of their business. Some venture capital firms specialize in certain industries or specific technologies. There are firms that only invest in, for instance, computer network technology businesses. Other firms only work with businesses in the biotechnology field. Consequently, VC firms that have such specialties turn away those businesses that don't fit into their area of expertise.
In recent years in there has been a pronounced emphasis on emerging technologyspecially computer-relatedy venture capitalists. In 1998, for example, almost two-thirds of all venture capital, or $7.8 billion, was devoted to information technology (IT) ventures, according to a VentureOne report. In particular, much of this money was funneled into IT communications applications, including Internet-based technologies. Health-related ventures (often also technological in nature) were a distant second, at $2.7 billion, or 21 percent of all venture capital.
Burrill, G. Steven, and Craig T. Norback. The Arthur Young Guide to Raising Venture Capital. Billings, MT: Liberty House, 1988.
Gibson, Paul. "The Art of Getting Funded." Electronic Business, March 1999.
Gladstone, David J. Venture Capital Handbook. Rev. ed. Englewood Cliffs, NJ: Prentice Hall, 1988.
Littman, Jonathan. "The New Face of Venture Capital." Electronic Business, March 1998.
VentureOne Corporation. "1998 Investment Highlights." Industry Data. San Francisco, 1999. Available from www.ventureone.com.