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Definition of a Venture Capitalist:
invest in companies that do not have access to the capital markets. Normally the companies are start-ups or rapidly growing and require capital to finance their growth. The risks are high, but so is the potential for high returns on investment.
What do Xerox, Apple, Avis, Intel, Twitter, and Genetech have in common? Each used venture capital to finance their growth. Venture capitalists seek huge returns from investing in smaller companies that do not have access to the capital markets. For example, Paul Thiel invested $500,000 in the social networking start-up, Facebook. Over several years, Thiel has sold most of his shares for over $1 billion!
What do venture capitalists look for? To be considered, a company must have a huge potential for growth, and comparative advantage. High tech and pharmaceutical companies have attracted a great deal of venture capital in the past decade because of their potential for enormous growth. Frequently venture capitalists invest in industries where they have some expertise because their familiarity adds comfort with the industry and they are able to contribute valuable insights. Ultimately, venture capitalists want to invest in companies that can be taken public, meaning the company is large and profitable enough where shares can be publicly traded on a stock exchange.
Venture capitalists protect their investments. Venture capital is not a loan, so the only way venture capitalists earn a return is through the appreciation of the company’s value. Choosing the best companies is essential. Venture capitalists are known for their due diligence. They may take months to become familiar with a company’s management, culture, and long-term vision. Normally their ownership interest is very high, sometimes over fifty percent. This assures them of control in important management decisions and a healthy profit if the company is successful.
Why would an entrepreneur consider using a venture capitalist? Perhaps the entrepreneur needs money to build a plant to manufacture its product. Maybe management wants to expand globally. The cost is high, and banks feel uncomfortable with the loan. Without the funds, the company’s growth would stall. The venture capitalist’s compensation is derived from the business’s profit. Unlike bank loans, valuable cash is not drained from the company to pay interest. Instead, the cash can be used to finance additional growth.
For example, Harriet has developed a lipstick that changes color with mood swings. She needs $2 million to begin the manufacturing process and market her product. She expects it to take several years before actually earning a profit, but she projects over 30 percent growth and an annual profit exceeding $1 million in three years. Banks tell Harriet to return after three years when she is profitable. That does not help her now! Venture Inc. is interested in financing her venture, but it requires a 40 percent ownership interest. They also insist on protecting their investment by controlling many of the most important management decisions. Harriet feels comfortable with this. In fact, she believes the expertise Venture Inc. brings to her company may prove very helpful. She chooses to accept the offer. After all, 60 percent of $1 million is greater than 100 percent of zero.
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