If you follow the technology industry, you’ve probably heard people talking about venture capitalism, and you may wonder what it is. Venture capital is money invested in a startup company in exchange for partial control of the company as well as shares of stock as they company grows in value. It’s similar to another commonly used term, angel investor, which refers to an individual who provides starting capital to a young, unproven company.
Active Financing
Usually, the companies receiving capital have big ideas and a strong business plan, and the venture capitalism firms and angel investors listening to their proposals see the potential for big rewards. Angel investors, especially, tend to take an active interest in the ideas of young entrepreneurs because, most of the time, these investors were once young entrepreneurs themselves who built successful companies and became wealthy by selling their shares of the firm. Financing sources such as venture capital, angel investing and private equity are different than lending from commercial banks because they don’t require existing equity as collateral, according to Investopedia. This difference makes these types of active financing riskier than commercial lending, but also gives them more bargaining leverage when it comes to returns on investment.
Investors in startup companies begin with little more than a group of talented people and an idea for a company that could become the next Apple or Facebook. A venture capital firm agrees to invest in the idea after spending time investigating the prospect and making sure that the risk is worth the potential return. Money from these groups comes in installments as the company meets certain agreed-upon milestones in its development. Part of the agreement to invest in a startup is usually one or more seats on the board of directors, so venture capital firms must actively work for their payment. The return comes five or six years later when the company has had time to establish itself and develop a plan for an initial public offering, or IPO. Alternatively, the company is developed enough so that it can be acquired by a larger firm in the same industry.
Profiting From Venture Capital
The venture capitalists take their share of the profit from the merger, acquisition or IPO, and then they exit the company. This exit is part of the plan to invest in the startup from the beginning, and the VC firm doesn’t continue participating in the company’s board meetings or future activities after the exit. However, an angel investor may continue to offer guidance to a company that he or she has taken a personal interest in.
Some politicians running for office have used the term “vulture capitalism” in a way that doesn’t quite make sense, but causes an emotional reaction in voters. It might be accurate to describe some private equity firms as vultures because they take over nearly bankrupt companies and scavenge them for value, but venture capitalists invest in companies that have virtually no value to start with. Private equity firms often lay off workers, but venture capitalists work with companies that haven’t hired workers yet.
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The ugly side of capitalism extends to much more than just mass layoffs of redundant workers, but it has produced most modern innovations and made scientific discoveries such as the size and age of the universe possible. Venture capitalism helps fuel this innovation and discovery by investing in ideas with the potential to change how people live.
