Startup financing: Venture capital (VC) and private equity

Private equity is a relatively new term. It can cause confusion as some in the investment industry use it to only refer to investing. Others use the term to describe the entire asset class of venture capital, buyout and mezzanine investing.

The CVCA, Canada’s Venture Capital and Private Equity Association, lists over 1,500 members who operate in these three different market segments. The CVCA defines venture capital as investments in early-stage companies, mostly in the technology sector.

What startups should know about venture capital (VC):

  • A VC is accountable to its investors—the people who have invested money in the VC’s funds.
  • VCs have to raise money every four years or so, and must justify their investment mandate and demonstrate a track record of making returns for investors.
  • A VC’s only responsibility is to make money for its investors. Given the risk profile of investments, VCs are expected to generate returns of about 20% to 30% (that is, above the returns of the public market).
  • Each fund has a specific mandate that the VC must follow in making its investments. This may be defined by geography, stage of investment, or specific technology sub-sectors.
  • VCs are willing to take risks to realize high returns but they look for ways to mitigate those risks.
  • VCs work by first performing due diligence, then providing hands-on assistance with strategy and business development once they make an investment.
  • VCs look for startups that have the potential to become a “home run.” Generally, only one out of ten companies accomplishes this. However, since the VC takes substantial risk and several of the remaining ventures fail completely, the “home run” potential must exist to cover for those investments that do not thrive.
  • VCs review up to 10 business opportunities per week with a goal of funding 2 to 3 businesses per year.
  • Successful VCs are generally visionaries who recognize areas of market opportunity before others, or just as the areas emerge.
  • The difference between an angel investor and a venture capital investor is the size and stage of investment. Angel investors provide a key bridge between seed and venture capital for growth companies. For more on angel investors, visit the National Angel Organization.

How venture capital works

  • VCs are generally entrepreneurs first and financiers second; they tend to participate in setting the strategy, management, planning and governance of the business.
  • Individual partners working at venture firms receive a portion of profits earned from returns on investments, referred to as carried interest. This motivates them to help their investments succeed.
  • The investment focus differs for VCs. Generally, early-stage venture capital funds focus more on sector and/or geography while later-stage investors take a broader approach.
  • VCs often invest in different stages.
  • The size of capital pools of funds can range from a few million dollars to over $1 billion.
  • A majority of VCs have a high-tech sector focus, but funds also exist that specialize in construction, industrial products, business services, retail, and the newly-emerging sector of “socially-responsible” startups.
  • The investment time horizon (the length time until the investor needs to sell) for returns may vary. Generally, VCs seek an exit in three to seven years, with up to ten years for earlier-stage deals.
  • Aside from independent VC firms, a number of companies take part in corporate venturing where they invest in early-stage companies whose products complement the parent company’s strategic technology, or in opportunities that provide synergy or cost-savings in their operations. In Canada, some examples include Telus Ventures® or funds associated with financial institutions.

Venture capital investing and boom and bust cycles

  • Depending on the opportunities for returns in the public markets, the amount of capital that flows into venture capital funds varies.
  • In a period of rising public markets, investors may achieve their target returns without exposure to the riskier asset class of venture capital investments; therefore, less capital may flow to VC funds.  However, investors may also consider public stocks overpriced and turn to earlier-stage investment opportunities.

In a recessionary period with a falling public market and a steep decline in real estate values, investors in VC funds may also worry that their percentage exposure to venture capital assets is rising in relation to their other assets; therefore, they may reduce their capital commitments to VC funds.


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References

Canada’s Venture Capital& Private Equity Association. Retrieved April 19, 2009, from http://www.cvca.ca.
National Venture Capital Association. Retrieved April 19, 2009, from http://www.nvca.org/def.html.
Tech Capital. Retrieved April 19, 2009, from .
National Angel Capital Organization. Retrieved April 19, 2009, from http://www.angelinvestor.ca.