What EXACTLY is venture capital and how does it work?
An economy is driven by invention and innovation. Invention and innovation also have a strong hold on the collective imagination of a country. And one of the most essential drivers of a developing digital economy is venture capital.
Those who are not in the industry may not be familiar with what venture capital is, and how it works. And more importantly, how does venture capital drive economies? And if you are into the startup system in the Philippines, a little knowledge and understanding about this vibrant, active, and changing industry, and how they actually drive economies, will help you understand why the venture capital industry has attracted even the biggest investors in tech and celebrities like Ashton Kutcher, Jay Z, and Oprah.
What is venture capital?
Venture capital (VC) is a type of financing offered by investors to startups and small businesses with the potential for long-term growth in exchange for equity, sometimes in the form of company shares. Venture capital can be offered by a wealthy investor or by a firm that specializes in funding entrepreneurs for their startups and small businesses.
Venture capital funding is not just a two-dimensional transaction. It also involves other key players that help keep the industry robust, as explained in this diagram below.
How does venture capital work?
Private investors put their money (and trust) to venture capital firms who can award funding to startups or small businesses that have potential significant growth in their market. In turn, they gain high returns from their investments.
Startup Entrepreneurs who may or may not receive early or seed stage support from corporations and the government pitch their ideas to venture capitalists for growth-stage funding, and when approved, are granted funding. In some cases, venture capitalists often lead funding rounds to give opportunities for other private equity investors to fund and help raise the amount needed by entrepreneurs for their startups or small businesses.
Investment bankers who are looking for companies that have the potential for high returns (by selling stock to public markets and corporations) may strike a partnership with venture capitalists. Venture capitalists, in turn, sell equity of the startups or small businesses they nurture to investment bankers via initial public offerings (IPOs).
So when you think about it, venture capital is essential in accelerating the growth of the digital economy for its key players.
Now let’s also list down other facts about venture capital:
Venture capital firms often fund young, and often tech-focused companies.
Contrary to popular belief, venture capital plays its role much later in the innovation life cycle of a startup or a small business - they actually come in when the latter starts to commercialize its innovation.
Over 80 percent of the venture capital funding received go towards building infrastructure and systems needed for a startup or small business to scale operations. In other words, depending on the type of business they are, they spend money on capital expenses such as marketing, sales, and manufacturing, and “balance sheet” investments (e.g. fixed assets and working capital). These investments aim to help a startup or small business reach sufficient size and credibility, making them a lucrative company to be absorbed.
When a startup or a small business has reached its growth goal, they can either go bigger or go home via an “exit strategy.” The startup or small business decides to either gain more capital (and liquidity) by selling equity (e.g. stocks) or sell the entire operations to a much larger organization or enterprise.
A venture capital deal is not always in a monetary form. Some deals can also be provided in the form of technical or managerial expertise, and in most cases, exclusive connections or networks. The more prestigious your venture capital firm, the more possible for a startup or a small business to gain subject matter and industry expertise (via mentorship or incubator programs staffed by the top experts in the industry). Moreover, the connections and networks in a venture capital deal are so exclusive that they pay off later either in strategic partnerships, more capital funding, to gaining access to a pool of talented people startups or small businesses need to expand.
What's another alluring feature about venture capital? It’s a calculated risk. They make significant investments and favor rapid company growth. Venture capital companies take calculated risks and follow strict regulations to ensure that, for every startup investment that fails, there is a unicorn that prevails.
Why should you care about venture capital?
Entrepreneur Nicolas Colin shared how important venture capital is in the digital economy, and why it is also thriving
“Venture capital exists in the digital economy not because it is riskier, but because it is in fact less risky than other parts of the economy when it comes to research and development. Venture capitalists are willing to finance radically innovative companies not because they’ve suddenly embraced the idea of risking everything, but because some traditional risks were eliminated forever by various public and private investments, notably in the technological platform that is the Internet.”
As more and more people (and businesses, organizations, and even governments) become more empowered to use technology for just about anything, the innovation and invention needs to catch up with the demand, hence the need for more entrepreneurs to come up with new technologies. As software continues to “eat the world” with next-wave technologies, venture capital will continue to thrive to support the next great idea, and the one after.