Venture capital is the name given to all those investments through shares that serve to finance small or medium-sized companies, usually startups (companies that are only a few years old and are in their first temporary phase).
These are companies that are not listed on the stock exchange and cannot obtain the desired financing in the public stock markets or through other traditional forms of corporate financing, such as from banks.
The companies seeking this type of capital or financing are generally small, high risk, with no history to back up their future cash flows (which are usually negative in their first years of life). Therefore, they are willing to offer significant equity positions to those who offer themselves as venture capital in exchange for growing the business.
Typically, there are very few tangible assets that can serve as collateral (security in relation to the loan transaction) in bank loans.
It is a high-risk operation, but private equity firms that specialize in this type of operation obtain high returns. Their business is to finance these types of entities, with the hope of profiting from a few highly profitable companies, taking stakes in the companies in which they invest. As we mentioned, cash flows are negative in their first years, so in many cases, the entire investment can be lost.
Among the advantages for those who engage in venture capital, it is not only the profitability they can obtain but also, the relevant experience, the contacts, and the strategic advice they can provide.
Regarding the time period, being a fairly illiquid investment, investors must commit and immobilize that capital for at least between 5 and 10 years approximately before exiting the company’s equity. At this point, an appropriate exit strategy should be planned to obtain a high value, as these stakes are usually exited in a Public Offering (IPO).
Stages of venture capital
- Fundraising. This stage typically lasts between 6 months and 1 year. The venture capital firm seeks funds from investors, but they are not invested at this stage.
- Investment search. Once the venture capital fund is closed to new investors, investment opportunities are sought. During this second stage, the funds raised are not invested, but the commission structure is designed. This stage can last up to five years.
- Investment commitment. At this stage, decisions are made on which companies to invest in and how much of the fund to allocate to each. At this stage, the funds are invested in companies, which generally do not provide positive returns. This stage usually coincides with the timeframe set in the previous stage and lasts between 3 and 5 years.
- Investment management. At this stage, all the capital has been invested. The venture capital firm begins to manage the portfolio of companies and provide them with business knowledge and experience. At this stage, the investment starts to generate profits, and an exit plan begins to develop.
- Fund liquidation. The fund is closed, and profits are distributed among investors and the venture capital firm (commisions).
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