Venture Capital – Definition

Cite this article as:"Venture Capital – Definition," in The Business Professor, updated June 2, 2019, last accessed December 4, 2020, https://thebusinessprofessor.com/lesson/venture-capital-definition/.

Back To: BUSINESS TRANSACTIONS, ANTITRUST, & SECURITIES LAW

Venture Capital Definition

— See also, Venture Capital Investment

New and emerging startup companies and small businesses require capital to develop their businesses. Venture Capitalists identify the technologies, products, concept or business ideas that have long term growth potential. They invest in such companies in exchange for partial ownership of the company.

Most often the venture capitalists are firm who invest in startups or small businesses. Individuals who invest in venture capital are commonly known as an angel investor. Angel investors often get involved earlier and take a smaller stake.

Venture Capitalists typically take an equity or ownership stake in exchange for their investment. Venture Capital is also known as risk capital, due to the risk factors attached to it. These investments are risky because there is very little certainty in the startup business, but at the same time, it has the potential to earn a huge return if the startup succeeds.

A Little More on What is Venture Capital

Typically, the venture capital investment rounds occur after an initial seed funding. The first round of institutional venture capital investment is called a Series A round. In this process, large ownership chunks of a company are created and sold to the investors through independent limited partnerships established by venture capital firms.

Venture Capitalists invest in a promising company in the interest of generating a return through an eventual “exit” event.  The exit event may come through an Initial Public Offering where the company sells its share to the public for the first time or it can be done through a merger and acquisition. The exit may also be done via the private equity secondary market.

One of the main differences between venture capital and other private equity deals lies in the fact that venture capital focuses on emerging small companies in need of significant funding for the first time, while private equity typically funds larger and more established companies.

History of Venture Capital

Prior to World War II, private equity primarily remained the domain of wealthy individuals and families. In 1946, for the first time, venture capitalist firms were established in the U.S. The first two firms were the American Research and Development Corporation (ARDC) and J.H. Whitney & Company.

Georges Doriot, a Harvard Business School professor along with Ralph Flanders and Karl Compton (former president of MIT) started the American Research and Development Corporation and raised a $3.5 million fund. Doriot is considered to be the Father of Venture Capital, his aim was to encourage private-sector investment in the companies run by soldiers returning from the Second World War. The American Research and Development Corporation is the first institution that raised capital from sources other than the wealthy families and individuals. The first ever investment made by the institution was in a company that had ambitions to use x-ray technology for cancer treatment. Doriot invested $200,000 in the company and when the company went public in 1955, it turned into $1.8 million. In 1957, ARDC invested $70,000 in Digital Equipment Corporation and after the Initial Public Offering in 1968, the company was valued at over $355 million.

The Small Business Investment Act of 1958 was passed by Congress to officially allow the U.S Small Business Administration to license private Small Business Investment Companies (SBICs). These SBICs were formed to help the financing and management of small entrepreneurial businesses.

During the 1960s and 1970s, the venture capitalists mainly concentrated on the companies who were working in the fields of electronic, medical or data processing technology, so much so that it became synonymous with technology finance. As a result, venture capital became a concentrate on the West Coast after the phenomenal development of the tech ecosystem in this region. However, the funds were mainly coming from the banks located in the Northeast. The first tech company that received venture capitalist funding was the Fairchild Semiconductor, a company started by the traitorous eight from William Shockley’s lab.

The venture capital market witnessed a gradual rise throughout the 1970s and 80s. However, in 1974 there was a temporary downturn when the stock market crashed. The National Venture Capital Association was formed in 1973.

The process followed in venture capital investment

The company seeking funding through venture capital investment need to submit a business plan to a venture capital firm or to an angel investor. The venture capitalist then reviews the business plan to estimate the growth potential of the business. If they find the business plan, they perform due diligence which includes a thorough investigation of the background of the company and its management, its operating history, product or service it offers, the business model it follows and others. Performing due diligence is a must for all venture capitalist and is very important before making any decision.

Generally, venture capitalists concentrate on a particular industry and gather thorough information and knowledge about the industry. After the background check if the investor is satisfied with the finding they may agree to invest capital in the company in exchange for equity. The venture capitalist may invest the whole amount at once, or it may provide the capital in rounds. The venture capitalists or angel investors may become a part of the board of directors or assumes a consulting role within the business. The aim is to keep a close watch on the business and its growth. They often take an active role in the company’s business and creates a positive impact on the growth trajectory of the business.

The venture capitalist or angel investor exit the company after a certain time either by initiating a merger and acquisition or by initial public offering. Typically, the venture investors take four to six years before exiting a company in which they have invested in.

Although apparently, it seems that raising venture capital investment is quite common, the truth is, historically less than 1% of businesses have been successful in securing a venture capital investment. According to Harvard Business School Review, venture capital investment is the exception, not the rule.

The PitchBook-NVCA Venture Monitor reports, by the end of 2018, the venture industry deployed $130.9 billion in US-based startups. It surpassed the all-time high in 2000. The report observes the late-stage financing has become more popular among venture capitalist firms, as they prefer less-risky ventures.

References for Venture Capital

Academic Research on Venture Capital

Venture capital at the crossroads, Bygrave, W. D., & Timmons, J. (1992).

Does venture capital spur innovation?, Kortum, S., & Lerner, J. (2001). In Entrepreneurial inputs and outcomes: New studies of entrepreneurship in the United States (pp. 1-44). Emerald Group Publishing Limited.

The structure and governance of venturecapital organizations, Sahlman, W. A. (1990). Journal of financial economics, 27(2), 473-521.

The venture capital revolution, Gompers, P., & Lerner, J. (2001). Journal of economic perspectives, 15(2), 145-168.

Grandstanding in the venture capital industry, Gompers, P. A. (1996). Journal of Financial economics, 42(1), 133-156.

Optimal investment, monitoring, and the staging of venture capital, Gompers, P. A. (1995). The journal of finance, 50(5), 1461-1489.

Venture capital and the structure of capital markets: banks versus stock markets, Black, B. S., & Gilson, R. J. (1998). Journal of financial economics, 47(3), 243-277.

The syndication of venture capital investments, Lerner, J. (1994). Financial management, 16-27.

Venture capital and the professionalization of start‐up firms: Empirical evidence, Hellmann, T., & Puri, M. (2002). The journal of finance, 57(1), 169-197.

Was this article helpful?