Venture capital recently piqued a lot of interest due to the popular TV show Shark Tank. In this show, aspiring entrepreneurs wanting to be the next big thing in business pitch their ideas to a couple of venture capitalists, who then decide whether to invest in their company or not. If you’re interested in venture capital investment, don’t take the Shark Tank producers’ word. Read more to learn the definition, as well as the pros and cons of venture capital.
What is Venture Capital?
Venture capital is a financing method used by companies to secure funding and investors to grow their wealth by infusing capital on startup companies with excellent growth potential. In practice, this investment tool is high risk and with virtually no guarantee for return on investment. Many investors don’t break even, and some never get any of their money back. However, the storied history of venture capital is enough to keep people interested.
Venture capital begins when startup founders pitch their idea and business strategy to prospective investors. Venture capital firms then pool capital from investors to organize venture funds. These funds are then used to buy equity at various stages in a startup’s life, either during the early or late stages. Venture capital investments are locked in until the occurrence of a liquidity event, such as the launch of an initial public offering (IPO). At this point, VC firms begin realizing profits from their capital infusion.
How Do You Invest in a Venture Capital
Traditionally, venture capital investing is reserved for the extremely wealthy, venture capital firms, or accredited investors. Investment banks also participate in venture capital by establishing partnerships. To become an accredited investor, the requirements are:
- an annual income of not below $200,000 if single,
- $300,000 annual income if you’re married, or
- accumulating a net worth, not beyond $1M.
However, the 2015 revised Jumpstart Our Business Startups Act transformed equity crowdfunding to become more inclusive. The byproduct of the law is that venture capital platforms became accessible to non-accredited investors.
Today, several startup platforms online provide the opportunity for non-accredited investors to infuse capital in startups for as low as $100. The only requirement is to register on the platform to browse opportunities and be involved in crowdfunding. Some of these sites allow anybody to invest like a venture capitalist:
- Angel List
Advantages of Investing in a Venture Capital
Despite being a high-risk investment, venture capital is characterized by often staggering returns. In exchange for infusing capital on a startup for two years, the expected return is ten times the initial capital.
The most successful companies, such as Facebook, Twitter, or Spotify, were fledgling startups buoyed by venture capital. Now, they are all billion-dollar companies, all poised for further growth. For their venture capitalists, the startup’s success meant record-high profits.
Take the case of Accel Partners, which in 2005 injected $12.7M to fund Facebook for a 10% stake at equity. When Facebook went public in 2012, it made around $9B.
On the non-financial side, there is a psychological reward from helping fledgling companies achieve their potential. In many instances, venture capital investors used to be startup founders and are using their wealth and connections to assist companies.
Disadvantages of Investing in a Venture Capital
While venture capital investment can command huge profits, it’s also extremely risky. Everything rides on whether the startup succeeds or fails. If a startup collapses, investors run the genuine possibility of a non-recovery of capital. Should the company still has remaining assets, the payment of outstanding debts are prioritized before what’s left is divided among investors as per the agreed-upon structure.
Even when the firm you invested in launches its IPO, its performance is still uncertain. The company’s initial stock value may not perform as high as expected. Therefore, if you decide to invest in venture capital, you should be prepared to lose it all.
Dependent on management
Whether or not you reap high rewards from venture capital investment relies heavily on the management team’s performance. Therefore, investing in venture capital in a firm is a gamble that rests on human competence. Due diligence is crucial in selecting a firm that is managed by a highly competent team.
Indeed, venture capital investment is a vehicle for financial growth in a relatively short time. However, the vast rewards to be expected of this investment comes with high risks. The most important thing is to proceed with caution, do your research, and be smart about your investment choices.