Venture capital is money provided to startups and small businesses the investors believe have long-term growth potential. Most venture capital comes from financial institutions or wealthy individual investors.
As might be expected, venture investing is risky but comes with the potential for very attractive returns – provided the investors choose carefully. For the startups or companies, venture capital can be a lifesaver, especially if the company does not have access to bank loans. The main downside is that the venture capital investors get equity in the company.
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The Venture Capital Process
The first thing that happens is the business seeking venture capital submits a business plan. That plan is reviewed by potential investors and if any are interested, they perform extremely elevated level due diligence, including a complete examination of the company’s business model, products, management and history.
Once the due diligence is finished, the investor may pledge a certain amount of capital in exchange for equity in the company. The investor (or investors) typically take an active role in the company providing advice and tracking progress as funds are released. After a pre-determined period, typically 4 to 6 years, the investor exits the company by initiating a merger, acquisition or initial public offering (IPO).
Investors in venture capital tend to be accredited investors, or those who have a net worth of at least $1 million. Money invested tends to be tied up for several years, which means investors must be willing to give up liquidity for the invested amount for that length of time.
Venture capital investing does provide portfolio diversification but at a cost. There may be high fees and costs. Getting involved with the wrong firm could result in poor decisions and a loss of most or all invested capital. Venture capital investing is not for the faint of heart.
Investing Via Crowdfunding
Regular investors obtained the right to invest directly in startups and new companies in 2015 with the advent of crowdfunding regulations under the Jumpstart Our Business Startups Act of 2012. Under these regulations you can invest up to $2,000 per year through equity crowdfunding. If 5% of your annual income or net worth (whichever is smaller) is greater than $2,000, then you can invest that larger amount. There are portals that offer listings of crowdfunded companies seeking financing. The minimum varies but some are as low as $100.
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Investing In Managers
Venture capital, as noted above, is risky business. Because of this, many investors prefer to invest in companies that provide venture capital, instead of investing in the startups themselves. Some venture capital and private equity manager trade publicly, which means you don’t have be an accredited investor or qualify for crowdfunding to invest. Among the more popular names in this space are Blackstone Group (NYSE:BXC), Carlyle Group (TSX:CGC) and KKR (NYSE:KKRB).
The downside to investing in managers is that you can’t choose one startup to receive your investment dollars. This tends to spread out the risk, but also lowers the return since bad investments are mixed in with the winners.