Venture capital is a prominent form of private equity investing that involves investment in earlier-stage businesses requiring capital. The investors, in return, tend to receive an equity stake in the business in the form of shares. Previously, Anand Jayapalan had spoken about how companies may raise venture capital for a myriad of reasons, ranging from supporting the development of new products and services to scaling the existing business. Owing to the capital intensive nature of starting a business, many venture backed enterprises tend to operate at a loss for several years prior to becoming profitable.
How does venture capital work?
Private equity investments are equity investments that are not traded on public exchanges like the New York Stock Exchange. Individual and institutional investors commonly invest in private equity through limited partnership agreements. This allows investors to invest in diverse venture capital projects while also preserving limited liability. Venture capital funds are also run in a manner similar to private equity funds, where the portfolio of businesses they invest in typically falls within a specific sector specialization.
Structure of a venture capital
A venture capital fund is commonly structured in the form of a partnership. Here the venture capital firm and its principals tend to serve as the general partners, while the investors serve as the limited partners. Limited partners may include wealthy individuals, university endowment funds, pension funds, insurance companies, and so on. Limited partners are passive investors. While all the partners do have an ownership stake in the venture company, it is the general partners who tend to be more hands-on. In fact, they might serve as board representatives, advisors or managers to companies they invest in. These are referred to as portfolio companies.
General partners and limited partners split the profits from the disposition of investments made in the various portfolio companies. Usually, general partners, also known as private equity fund managers, get about 20% of the profits as a performance incentive. The other 80% of any profits are generally divided equally among the limited partners investing in the fund.
Venture capital exit strategies
The process that allows venture capitalists to realize their returns is called an “exit.” They may exit at different stages.
- Secondary market sales: Venture capitalists who have invested in the earlier stage can sell off their holdings to new investors during the later rounds, before the company goes public. As the shares have not been issued in the public exchanges, the trades tend to take place in the private equity secondary market.
- Acquisition: Acquiring the investee company is another popular exist strategy. In this situation, the acquirer is generally a strategic buyer interested in the technology and growth of the investee company.
- Initial public offering (IPO): If a company is doing well enough and moving to the public exchange, the venture capitalists may take the IPO strategy by selling off their portions of shares in the open marketplace after the IPO.
Earlier, Anand Jayapalan had mentioned that there generally is a lock-up period after the initial offering where insiders including venture capitalists, are not allowed to sell their shares. The length of the lock-up period is typically specified in the contract.
