What Does Venture Capitalist Mean?

Table of Contents

1. What Does Venture Capitalist Mean?

2. History of Venture Capitalist Firms

3. Venture Capitalism 101

4. Misconception About Venture Capitalists

5. Venture Capitalist Firms’ Investment Strategy

6. Venture capitalist regulations

7. Venture capitalist firms’ limited partners

8. How Do Venture Capitalist Firms Make Money?

9. The Structure of a VC Firm

10. Summary

What Does Venture Capitalist Mean?

A venture capitalist, sometimes called a VC, is an investor (either an individual or a company) who provides a small company with capital in exchange for an equity stake in their business. They usually work with startups or small businesses that are not publicly traded and need capital to grow their business.

These businesses turn to venture capitalist firms because they may not be able to secure traditional loans. Startups carry a lot of risks and, therefore, attract high interest rates (more than usury laws permit banks to charge). Generally, these startups are seeking funding to increase assets and, therefore, cannot even secure a bank loan against hard assets. This is why they turn to venture capitalist firms. Venture capitalist firms take on that risk in exchange for an equity partnership.

Venture capitalists tend to be selective in their investments because it is an extremely risky type of investment. VCs have an equity stake in the company, so they only make money if the company is profitable. Not every startup is the next Facebook; many startups fail or take a little while to turn a profit. For example, Uber was in business for 14 years before it registered its first profit.

A venture capitalist typically requires the expertise of a corporate lawyer, particularly one specializing in venture capital and private equity. This type of lawyer has a deep understanding of investment law, securities regulation, and the specific legal needs of startups and growth companies.

History of Venture Capitalist Firms

Venture capitalist history dates back to the 20^th century. Here is a timeline of the history of venture capitalist firms.

1946: The First Venture Capitalist Firm is Founded

Venture capitalism dates back to 1946. The first venture capitalist firm was ARDC (American Research and Development Corporation. Before ARDC, investors would seek investment from wealthy families. The Vanderbilts and the Rockefellers were big supporters of American businesses.

When the ARDC started, it leveled the playing field by allowing people who didn’t have connections to access business loans. The first investors in the first venture capitalist firm were insurers and educational institutions.

1958: The Investment Act is Passed

This enabled venture capitalist firms to be licensed by the SBA (Small Business Administration). There were no established standards of practice for venture capitalist firms started around this time. These firms set many of the practices in use today, such as:

Limited partnerships were created to hold investments.
Professionals acted as general partners.
Investors who provided capital served as passive partners so that they had limited control.

1973: The National Venture Capital Association was Founded

The NVCA was formed to advocate on behalf of venture capitalist firms. Some of their activities include requesting regulations that stimulate innovation, securing favorable tax treatments, and seeking regulatory reforms.

Venture Capitalism 101

Venture capitalist firms seek to identify emerging growth sectors or companies so they can maximize the return on their investments. While the payoff is huge when VCs get their investment choices right, there is a large rate of failure because the companies they invest in are unproven.

Misconception About Venture Capitalists

A common misconception about venture capitalists is that they drive new businesses by giving startups the money to start a new business. They do not. Venture capitalist firms get involved once the company has established itself. They fund the startup as it grows into the next stage of the lifecycle, where significant capital is needed to build infrastructure or expand operations.

Venture Capitalist Firms’ Investment Strategy

Because venture capitalism is so risky, venture capitalists have set criteria for their investments. Each VC firm will have its own strategy that looks at the following factors that indicate the growth potential of the company:

A large potential market
Competitive advantage
Strong management team
Unique product or service

Venture capitalist firms will specialize in particular industries as this allows them to act in an advisory capacity and further protect their investment. For that same reason, they will usually make a large enough investment to give them a significant stake in the company and, therefore, influence strategy. This is similar to what you may see on Shark Tank.

The firm will buy an equity stake in the company – giving the company some much-needed capital, and the venture capitalist firm shares in the company’s profit.

In general, venture capitalist firms will invest in companies in emerging growth industries. This is an industry or sector that is predicted to experience growth as a whole, and therefore, the companies in it will experience growth. In theory, as long as the startup has a strong management team and a good product or service, the company should experience growth. The venture capitalist firm will further reduce its risk by purchasing an equity share large enough that it will have a board presence and, therefore, be able to guide strategy and decision-making.

Venture capitalist regulations

Like any financial institution, venture capitalist firms are governed by the US Securities and Exchange Commissions, the same as banks. They must follow anti-money laundering regulations and anti-usury lending.

Venture capitalist firms’ limited partners

The investors in a venture capitalist firm are referred to as limited partners as they provide the capital but have limited decision-making power. Limited partners can be anyone – both businesses and individuals can invest in venture capitalist firms. Many venture capitalist firms are also publicly traded, so investment bankers will invest in the stock of venture capital firms.

How Do Venture Capitalist Firms Make Money?

Venture capitalist firms have investors, too. Their investors are limited partners to keep the investment decisions in the VC firm. The venture capitalist firm will take approximately 20% of the profits from their investments. (Each VC firm sets their amount.) The rest of the profits will be paid to the limited partners based on their original investment amount. In addition to the 20% profits, venture capitalist firms often charge management fees (similar to a stock broker charging management fees on stock portfolios.)

Here is a breakdown of how venture capitalist firms split the profits:

The venture capitalist firm takes approximately 20% of the profits.
General partners in the venture capitalist firm will collect a fee of approximately 2%.
The remaining profit will be split amongst limited partners.

The Structure of a VC Firm

A venture capitalist firm has its own investors who provide it with a pool of money that it uses to provide capital to the companies the VC firm invests in. These investors are called limited partners. They invest in the company and take a cut of the venture capitalist firm’s profit but they have limited say in the decisions of the firm.

Within the venture capitalist firm, there are a number of roles required to analyze the investment opportunities and make strategic decisions about both the VC firm and its investments.

Positions in a venture capitalist firm can be sorted into 3 categories:

Associates – Associates in a VC firm have a background in either finance or business consulting. These are the analysts who provide decision-makers with data to help them decide if a company is a wise investment. In many venture capitalist firms, associates will also analyze companies that the firm is already investing in to help the firm advise the company better. This may include analyzing industry trends, business models, or even a company’s business plan.
Principals – Principals are the mid-level professionals who will serve as the venture capitalist firm’s representative on the board of the companies they invest in. They will present the partners with the deals they believe the VC firm should invest in and negotiate deals. Their performance is based on the performance of the deals they make.
Partners – Partners in a venture capitalist firm are people who have worked their way up the ladder. There are hierarchies amongst the partners in a venture capitalist firm. The partners will generally approve deals and identify growth sectors the firm wants to invest in and feed that information to the principals and associates to find investment opportunities. Partners will manage a portfolio of companies (up to 10, depending on the VC firm.) They will act as a consultant to these companies, but due to the number of companies in their portfolio, the time they spend with each company is limited.

Summary

In summary, a venture capitalist firm is a company that provides startups with capital when they would otherwise struggle to obtain a traditional loan. Private investors invest in the venture capitalist firm as limited partners, providing the capital. The venture capitalist firm then invests in startups in exchange for equity partnership. The investment profits will be split between the firm (approximately 20%), limited partners, and partners may take a 2% fee on profits in their portfolio.

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