How Does VC Make Money

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 5 minute read

Although starting a business is exhilarating, many fail because they fail to account for the high costs associated with rapid expansion.

To expand, many new businesses require funding from investors. It’s common for lenders, investment banks, and the capital markets to pass on startups because of the considerable risk involved in funding them.

For this reason, there are people called venture capitalists. These backers are ready to put millions of dollars into up-and-coming companies on the off chance that their wagers may pay off.

What Is the Definition of a Venture Capitalist (VC)?

The term “venture capitalist” refers to a private investor who puts money into startups in exchange for a portion of the company’s stock. But unlike individual investors, VC firms function as a group.

They work for companies that invest in riskier enterprises, known as VC firms. Venture capitalists are on the lookout for fast-growing businesses with a distinctive offering and a sizable potential customer base.

To put it another way, these businesses have just entered the commercialization phase of the business cycle, which means their products are only now becoming available to consumers. They present an unacceptable level of risk for most financial institutions.

Venture capitalists often aim to acquire significant (commonly 20% to 50%) shares in the firms they support. They find that joining the boards of directors and monitoring the company’s management is an effective way to mitigate the risks associated with such investments.

How Venture Capital Operates

Venture capital businesses often take the form of limited partnerships. The VC firm takes on the role of general partner, or the partner with ultimate decision-making authority, while the investors take on the role of limited partners.

Accredited institutional investors, such as rich people, foundations, pension funds, and insurance companies, frequently create these types of businesses.

After the fund has been established and capitalized by the investors, it will seek for chances to make investments in promising new businesses. The fund is specifically interested in businesses that:

  • Use a One-of-a-Kind Item. The product has to be novel enough to offer a solution to a common problem that no other goods offer.
  • Get Some Proceeds from Your Products. Investors want to make an early bet. However, they often aren’t looking to put money into businesses that aren’t yet making a profit. To this end, they look for products that are just entering the commercialization phase and showing strong early sales results.
  • Aim for a sizable niche market. These backers aren’t looking for startups with a $2 million or $3 million yearly sales potential. They put money into businesses that aim for the public and might make hundreds of millions of dollars annually if things go correctly.
  • Maintain a strong management group. Venture capitalists provide assistance to management teams since they often hold a sizable chunk of the businesses in which they invest. They are interested in investing, but only if they are confident the management team is already on the correct course.
  • Possess the right to use one’s own ideas. The vast majority of venture capitalists seek out businesses that have established intellectual property in the form of patents, trademarks, and the like. Warren Buffett refers to them as “economic moat” elements.

When a venture capital firm identifies a promising startup to fund, it begins discussions with the prospective client to determine the terms of the firm’s investment and its eventual ownership position in the business. Successfully investing means the corporation will have a sizable stake in the developing business.

As time goes on, the investment firm’s partners get more involved with the businesses it backs by joining the boards of directors. They want the firm to expand as rapidly as possible so that one of three things happens:

  • First Public Offering (IPO). The company’s objective may be to expand to the point where it is attractive to public capital markets. It is now prepared to list its shares in an initial public offering at a far greater valuation than it paid when it invested.
  • Acquisition. In certain instances, the venture capital fund grows the firm it invests in with an eye on a buyout. This is frequently the case in sectors dominated by a few behemoth-sized corporations ready to make substantial expenditures in new technology to preserve their leading positions.
  • VC Acquisition. The VC firm may determine that acquiring 100 percent of the company over time and generating profits through corporate operations is its best choice.

Many backers of VC funds do not actively participate in the company’s operations. The business, however, is managed by the proactive parties, who get management fees.

The average management charge is 20% of the returns on an investor’s capital. The high stakes involved in funding startups mean that not all VC firms can turn a profit. Unfortunately, venture capital investments seldom pay off.

Qualifications for Venture Capitalists

Diverse types of people can be found among venture investors. Although there is no hard and fast rule on what it takes to become one, here are some good bets:

  • Complete Schooling. The typical educational level of a venture capitalist is the Bachelor’s. Get a degree in business or finance if you want to join their ranks.
  • In-depth work history. Venture capitalists often have a hands-on role in the businesses they fund. Prior experience working in the field in which you intend to invest is very desirable.
  • Possessing a Powerful Connection Structure. “It’s not what you know, it’s who you know,” is a common adage. If you want to make it big in the venture capital industry, you need to have a touch of both. Do not let go of a chance to create a lasting relationship with a pioneer in your field.
  • In the role of a guide. There is no mandate for having a mentor, although it is highly recommended. If you’re passionate about business, you probably know a lot of influential people either through your professional or social networks. Connect with these influential people and establish rapport with them. You should ask them to mentor you when you’re ready. Regardless of their own degree of achievement, most individuals are prepared to pitch in and assist others achieve their goals.

Bottom Line

One of America’s most vital sectors is the venture capital market. The early venture capital investments of many firms that provide items you know and love would have caused them to fail. Companies like Facebook, Apple, and Tesla are all examples of businesses that were able to successfully attract venture capital and go on to become industry leaders.

In addition to their financial success, VCs tend to be quite well off. They amass money thanks to their extraordinary capacity to investigate and evaluate start-up investment ideas, and then to take charge of underperforming businesses and lead them to success.

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