What is Venture Capital?

Venture capital is a means of financing fast-growing private companies. Finance may be required for the start-up, development/expansion or purchase of a company via a mechanism such as in a management buyout.

Growing businesses always require capital. There are a number of different ways to fund growth. These include the owner's own capital, arranging debt finance or seeking an equity partner, as is the case with venture capital.

With venture capital, the venture capitalist acquires an agreed proportion of the equity of the company in return for the requisite funding. Equity finance offers the significant advantage of having no interest charges. It is patient capital that seeks a return through long-term capital gain rather than immediate and regular interest payments.

Venture capital investors are exposed, therefore, to the risk of the company failing. As a result the venture capitalist must look to invest in companies that have the ability to grow very successfully and give higher-than-average returns to compensate for the risk.

When venture capitalists invest in a business they become part-owners and typically require a seat on the company's board of directors. They tend to take a minority share in the company and usually do not take day-to-day control. Rather, professional venture capitalists act as mentors and aim to provide support and advice on a range of management and technical issues to assist the company to develop its full potential.

Surveys in the US consistently rate the management support as the most important contribution of a venture capital firm. There are many sources of capital, but only a venture capitalist can provide experienced management input gained by helping many other companies successfully conquer the inevitable problems and growing pains.

Stages of Development

All businesses have a 'life cycle' which involves a number of stages of growth and development. Venture capitalists refer to these stages when making investments. Briefly, they are as follows:

Seed Stage

The venture is at the idea stage or may be in the process of being organised and needs finance for research and development. This is usually funded by the entrepreneur's own resources.

Early Stage

The company is in the process of being set up or may have been in business for a short time. Such firms have not yet sold their product commercially and have no track record. Investee companies have completed the product development stage and require funds to initiate commercial manufacturing and sales.

Expansion/Development Stage

The company is now established and requires capital for growth and expansion. The company may or may not have made a profit at this stage. This is a period of rapid growth and the company will usually require several rounds of capital injection as it achieves the milestones set in the business plan.

Management Buyout (MBO)

These are funds provided to enable a current operating management and investors to acquire an existing product or business from a public or private company.

Management Buy-in (MBI)

These are funds provided to enable a manager or group of managers from outside the company to buy in to the company.

Size of Investment

The size of investment is closely related to the stage of investment.

On the whole, early-stage investments require less capital than an expansion or MBO stage. Venture capitalists spend the same amount of time and effort assessing and assisting an early-stage company as they do a later-stage company. In fact, the earlier-stage companies usually require greater assistance than later-stage companies. Therefore, many venture capital firms prefer to invest in later-stage deals that fit their investment criteria.

There are a number of venture capital firms that specialise in investing in particular stages such as early stage, expansion or MBOs and MBIs. While each venture capitalist will have their own investment range, as a guide, venture capitalists invest between $1 million and $10 million (or larger).

Industry Sectors

The Australian venture capital industry invests in a wide range of industry sectors. According to the annual AVCAL survey undertaken by Venture Economics in conjunction with Arthur Andersen, the most popular industries are manufacturing, computer software, internet, distribution/retailing, IT services, business services and communications.

Some venture capital firms have funds that specialise in particular industry sectors such as bioscience, information technology or manufacturing. Many firms will actively avoid investing in sectors such as property, mining and farming.

Geographic Location

Venture capitalists in Australia tend to have investments in many different geographic locations. While they may like to invest in companies that they can easily access, a venture capitalist will place much more emphasis on other attributes the company has to offer.