A good analogy I read was that the entrepreneur is like the modern day cowboy, roaming the new industrial frontiers. The venture capitalist is standing at their side, a streetwise sidekick ready to help the hero through the tight spots, in exchange for a decent piece of the pie.

Put simply venture capital firms (or VCs as they are known) provide capital to companies in exchange for an equity stake. The businesses they are investing in are usually start ups, with growth potential.

The Investment is usually short term. The VC is investing in a company’s infrastructure until it gets to the point where it can either be sold, or secure more formal private or public funding. The VC partner is essentially investing in an idea, incubating and nurturing it for a short timeframe, and then exiting (selling their equity stake) when possible.

High risk high reward…

Yes these investments are risky. The companies seeking investment tend to be early stage with big growth plans. They may be pre revenue or in development stage, with limited historical financial information to go out and secure other traditional forms of lending. VC funding is often one of the only options available to businesses in this stage, and this is priced into the deal. Ultimately this is high priced capital.

So VCs operate in choppy waters. Their challenge is to consistently drive strong returns from investments made into inherently risky companies.

So how do they do it?

A VC will look for a strong management team with a track record of success, either with that business or with previous projects. The ability to execute the business plan is key, and VCs will want to see past experience of that. Again there is further risk here, as management teams come and go, and they are ultimately human – so VCs are investing heavily in the human side of the equation.

And where does the money come from?

First VC’s need to raise the funds to invest into the target Companies.  Investors into these funds tend to be large institutions like pension funds, insurance companies, and banks. These institutions will all earmark a small percentage of their wider investments into these higher risk investments. They will all expect a return of between 25% and 35% per annum over the lifetime of the investment. That’s some serious return!

How do the VCs attract this institutional investment? They have to show that they are consistently investing into high growth sectors, and structuring deals well. They will not want to take risks in completely unproven market sectors or low growth industries.

By investing in high growth sectors, they are shifting the risk away from the product or service and towards the management team and their ability to execute.

How does the industry work?

VC firms will often protect themselves by co-investing with other firms. There may be one lead investor, and several followers. This can add credibility to the deal, it also shares the workload around due diligence and risk assessment at the outset.

The key players who make the wheels turn are 1) The Entrepreneur who needs capital, 2) Investors who are looking for high returns, 3) Investment Bankers who need companies to buy and sell, and 4) VC Firms who make returns for themselves by making the market for the other three.

Figures vary by industry, but VC firms might expect to get x10 return on capital over a five year cycle. The VC firms will pay back all of the investor’s capital before they share in any upside. The fund will usually also charge a management fee to cover their costs.

So what are the Pros and Cons…?

Aside from the cold hard cash VC firms can provide a valuable source of industry knowledge, advice and support. They can bring a wealth of experience in financial and human resource management. VCs are usually very well connected in the business community.

On the downside, VC funding has been referred to as equity financing on steroids. The VC partners are definitely going to want to be involved day to day, and will want to have a significant hand in shaping the direction of your company. Depending on the equity stake, you may also end up losing majority control of your Company.

That could be a bitter pill to swallow for the baby you created, but it might be the only way to get it to the next stage.