Whenever the latest and greatest Internet start-up goes public in an IPO, the financial media is quick to point out the various venture-capital funds that stand to make truckloads of cash from the deal.
Many of you have probably wondered what venture capital means. Let's break down what venture capital is, how it works, and why the most prominent start-up companies use it.
What does venture capital mean?
Venture capital, or VC, describes a type of investing in which accredited investors buy equity in young companies that show promise to grow quickly and become large, viable companies. It's a highly risky strategy. Most start-ups fail, a few succeed, and only the rare few make it all the way to an IPO.
When a start-up needs money to fund growth, expand inventory, or hire more employees, it oftentimes lacks the cash to pay for those expenses. Banks won't give it a loan because the business is so young and oftentimes unprofitable, and there isn't adequate collateral. Enter the venture capitalist.
The venture capitalist, or venture capital fund, will provide the needed funds to the start-up in exchange for a percentage ownership in the company. This type of fundraising is called venture capital.
The start-up gives away some of its equity to get the cash it needs to continue growing rapidly, and the venture capitalist accepts the high risk of the funding in hopes that the start-up will grow quickly and provide an outsized return on the investment.
In addition to the cash, many venture-capital investors bring valuable connections and expertise to the deal. The venture capitalist may be able to introduce the entrepreneur to someone who can open up new opportunities for sales, distribution, or efficiency. Sometimes start-ups will accept venture capital funding not because they necessarily need the cash, but instead to gain access to the venture capitalist's connections and mentorship.
The ultimate success, and it is very rare, is for the start-up to one day go public in an IPO. More commonly, another company will acquire the start-up. More common even still, the start-up fails and the venture capital investors lose their money. This is a high-risk, high-reward business.
How does venture capital work?
When a start-up raises venture capital, it must go through an arduous process called due diligence.
The entrepreneur and/or management team at the start-up will provide the prospective venture capital funds with a business plan, including a budget of how the new funds will be deployed. The plan should include information about the product or service, the addressable market for future growth, an operating plan, and an explanation of any previous fundraising.
Many times, this information will be presented as a slideshow, followed by a question-and-answer session with the venture capitalists.
If the investors are interested, they will usually begin an in-depth review of the start-up, including background checks on the management team, verification of everything presented in the business plan, an audit of the financial statements, and more. No stone is left unturned.
If at this point the VC wants to invest, it will present the start-up with a term sheet outlining a proposed deal. The two parties will negotiate the specifics -- the dollar amount to be invested, the equity to be sold to the VC, and any other requirements on a case-by-case basis.
Finally, after all that work, the VC will invest in the start-up. At that point, the start-up will deploy the funds to grow the company and the VC will assist as appropriate with strategy, networking, and other expertise.
If everything goes to plan, then in time the company will have grown rapidly and will be sold or taken into an IPO. This process can sometimes take years, meaning the start-up's growth must be fast and also sustained.
Most start-ups fail to make it the whole way, but every now and again one will dramatically exceed expectations. Facebook is a great example. Accel Partners invested $12.7 million in 2005. That investment was worth about $9 billion when Facebook went public in 2012. Venture capitalists make their mint on these outsized paydays; it makes it worth it to accept the high risk of failure on the hundreds of other deals they do that don't work out.
The bottom line on venture capital
Being a venture capital investor is not for the faint of heart. Startups are far more likely to go belly up than to one day ring the opening bell on the New York Stock Exchange.
That said, venture capital is a critical component of how start-ups grow from a parent's basement to a billion-dollar public company. When promising companies need cash, venture capital firms are there to cut checks. The VCs provide funding, expertise, and mentoring, while the start-up gets the cash it needs to continue growing.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Facebook. The Motley Fool owns shares of Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.