What is a Venture Capitalist?
A venture capitalist is a person or group who provides investment capital to a start-up venture. A venture capitalist’s participation in an investment deal is a form of equity financing. Their goal is to invest in businesses that are promising in terms of producing high rates of return. The transaction in a venture capitalist investment is as follows:
- The venture capitalist supplies capital in exchange for taking equity or ownership in the company.
Equity financing such as this is popular among non-established businesses. Non-established businesses may choose to have a venture capitalist invest in their business because they are unable to secure business loans from financial institutions. Venture capitalists look for a strong management team because they understand new businesses may lack cash flow or collateral which deems them high-risk. They also look for a large potential market and a unique product or service. Venture capitalists are usually quite familiar with industries they choose to invest in, this gives them strong influence should the company begin to yield high returns.
A venture capitalist will want to obtain a large portion of control of the company in exchange for providing funds to a start-up business. By bringing in experience and capital, it is common for venture capitalists to obtain majority voting rights, in addition to special veto rights in a transaction such as this. A venture capitalist is usually in it for the long haul, looking to part with the company once it is ready for an initial public offering.
Example of a Venture Capitalist
Fund seeking companies that show promise for high returns are absolutely on a venture capitalist’s radar. A venture capitalist will likely maintain his portion of ownership in the company if the company yields consistent high returns year after year.
For example, let’s say a venture capitalist meets with the directors of a start-up company. The startup company’s current operations and long-term business plans show exceptional promise considering the industry’s competition, so the venture capitalist invests $2 million in the startup. The terms of the investment states that the investor receives 30% annual return on the $3 million invested and has 45% ownership in the company. This means that each year, the company must issue $600,000 to the investor. Five years in, the company has paid out $3,000,000 to the investor. Now, the goal for the investor and the company is to be in a place where cash flow is positive where the company can survive on its own. Should the company want to take back control from the investor, they would have to buy him out to avoid paying $600,000 a year. Keep in mind however, at this point, the company has grown in value, so the investor will likely adjust the price of his portion of the company upon selling, which means it will probably cost more than $2 million in this example to buy the venture capitalist out.
Venture capitalist investments are equity financing deals where startups give up a portion of control of the company for capital needed to expand or grow the business. A venture capitalist’s goal is to invest in a company that has promise to yield high returns and dominate its industry. Entrepreneurs may not accept an offer from a venture capitalist because striking a deal with a venture capitalist means giving up some or a big chunk of control. All in all, if you are a start-up company seeking capital to grow or expand your business, it is absolutely crucial to consider the percentage of control your willing to give up in addition to the rate of return your willing to pay out to the investor on a regular basis.