Venture Capital

The term venture capital does not have a precise meaning, but it generally refers to financing for new, often high-risk ventures. For example, before it went public, Netscape Communications was VC financed. Individual venture capitalists invest their own money; so-called "angels" are usually individual VC investors, but they tend to specialize in smaller deals. Venture capital firms specialize in pooling funds from various sources and investing them. The underlying sources of funds for such firms include individuals, pension funds, insurance companies, large corporations, and even university endowment funds. The broad term private equity is often used to label the rapidly growing area of equity financing for nonpublic companies.2

Venture capitalists and venture capital firms recognize that many or even most new ventures will not fly, but the occasional one will. The potential profits are enormous in such cases. To limit their risk, venture capitalists generally provide financing in stages. At each stage, enough money is invested to reach the next milestone or planning stage. For example, the first-stage financing might be enough to get a prototype built and a manufacturing plan completed. Based on the results, the second-stage financing might be a major investment needed to actually begin manufacturing, marketing, and distribution. There might be many such stages, each of which represents a key step in the process of growing the company.

Venture capital firms often specialize in different stages. Some specialize in very early "seed money," or ground floor, financing. In contrast, financing in the later stages might come from venture capitalists specializing in so-called mezzanine level financing, where mezzanine level refers to the level just above the ground floor.

The fact that financing is available in stages and is contingent on specified goals being met is a powerful motivating force for the firm's founders. Often, the founders receive relatively little in the way of salary and have substantial portions of their personal

2So-called vulture capitalists specialize in high-risk investments in established, but financially distressed, firms. Vulgar capitalists invest in firms that have bad taste (O.K., we made up this last bit).

Ross et al.: Fundamentals I VI. Cost of Capital and I 16. Raising Capital I I © The McGraw-Hill of Corporate Finance, Sixth Long-Term Financial Companies, 2002

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assets tied up in the business. At each stage of financing, the value of the founder's stake grows and the probability of success rises.

In addition to providing financing, venture capitalists often actively participate in running the firm, providing the benefit of experience with previous start-ups as well as general business expertise. This is especially true when the firm's founders have little or no hands-on experience in running a company.

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