A type of private equity capital typically provided by professional, institutionally-backed outside investors to new, growth businesses. Venture capital investments are usually high risk, but offer the potential for above-average returns.

A venture capitalist is a person who makes such investments. A VCF is a pooled investment vehicle (often a partnership) that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies with limited operating history, who cannot raise funds through a debt issue. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity.

Beginnings of modern venture capital

General Georges Doriot is considered to be the father of the modern venture capital industry.In 1946, Doriot founded American Research and Development Corporation whose biggest success was Digital Equipment Corporation. When DEC went public in 1968 it provided AR&D with 101% annualized Return on Investment. ARD's $70,000 USD investment in DEC in 1959 had a market value of $37 million USD in 1968. It is commonly accepted that the first venture-backed startup is Fairchild Semiconductor, funded in 1959. Venture capital investments, before World War II, were primarily the sphere of influence of wealthy individuals and families. One of the first steps toward a professionally-managed venture capital industry was the passage of the Small Business Investment Act of 1958.

The 1958 Act officially allowed the U.S. Small Business Administration to license private "Small Business Investment Companies" to help the financing and management of the small entrepreneurial businesses in the US. Passage of the Act addressed concerns raised in a Federal Reserve Board report to Congress that concluded that a major gap existed in the capital markets for long-term funding for growth-oriented small businesses. Facilitating the flow of capital through the economy up to the pioneering small concerns in order to stimulate the U.S. economy was and still is the main goal of the SBIC program today.

Generally, venture capital is closely associated with the technologically innovative ventures and mostly in the US. Due to structural restrictions imposed on American banks in the 1930s there was no private merchant banking industry in the US, a situation that was quite unique in developed nations. As late as the 1980s the USA's financial regulation framework was not able to support any merchant bank other than one that is run by the US Congress in the form of federally funded projects. These, he argued, were massive in scale, but also politically motivated, too focused on defense, housing and such specialized technologies as space exploration, agriculture, and aerospace. US investment banks were confined to handling large M&A transactions, the issue of equity and debt securities, and, often, the breakup of industrial concerns to access their pension fund surplus or sell off infrastructural capital for big gains.

Not only was the lax regulation of this situation very heavily criticized at the time, this industrial policy differed from that of other industrialized rivals—notably Germany and Japan—which at that time were gaining ground in automotive and consumer electronics markets globally. However, those nations were also becoming somewhat more dependent on central bank and elite academic judgment, rather than the more diffuse way that priorities were set by government and private investors in the US. 

During the 1960s and 1970s, venture capital firms focused their investment activity primarily on starting and expanding companies. exploiting breakthroughs in electronic, medical or data-processing technology. As a result, venture capital came to be almost synonymous with technology finance. Venture capital firms suffered a temporary downturn in 1974, when the stock market crashed and investors were naturally wary of this new kind of investment fund. 1978 was the first big year for venture capital, when the industry raised $750 thousand.

In 1980, legislation made it possible for pension funds to invest in alternative assets classes such as venture capital firms. 1983 was the boom year with over 100 initial public offerings for the first time in U.S. history. That year was also the year that many of today's largest and most prominent firms were founded.

Due to the excess of IPOs and the inexperience of many venture capital fund managers, VC returns were very low through the 1980s. VC firms retrenched, working hard to make their portfolio companies successful. The work paid off and returns began climbing back up.

The late 1990s were a boom time for the globally-renowned VC firms on Sand Hill Road in the San Francisco Bay Area. A number of large IPOs had taken place, and access to "friends and family" shares was becoming a major determiner of who would benefit from any such IPO; Common investors would have had no chance to invest at the strike price in this stage.

The NASDAQ crash and technology slump that started in March 2000 shook some VC funds significantly by disastrous losses from overvalued and non-performing startups. By 2003 many firms were forced to write off companies they had funded just a few years earlier, and many funds were found "under water" Venture capital investors sought to reduce the large commitments they had made to venture capital funds. By mid-2003, the venture capital industry would shrivel to about half its present capacity. The revival of an Internet-driven environment (thanks to deals such as eBay's purchase of Skype, the News Corporation's purchase of MySpace.com, and the very-successful Google.com IPO) have helped to revive the VC environment with over $60billion in debt.

Venture capital general partners are the executives in the firm, in other words the investment professionals. Typical career backgrounds vary, but many are former chief executives at firms similar to those which the partnership finances and other senior executives in technology companies.

Investors in venture capital funds are known as limited partners. This constituency comprises both high net worth individuals and institutions with large amounts of available capital, such as state and private pension funds, university financial endowments, foundations, insurance companies, and pooled investment vehicles, called fund of funds.

Venture partners "bring in deals" and receive income only on deals they work on (as opposed to general partners who receive income on all deals). EIRs are experts in a particular domain and perform due diligence on potential deals. EIRs are engaged by VC firms temporarily (six to 18 months) and are expected to develop and pitch startup ideas to their host firm. Some EIR's move on to roles such as Chief Technology Officer at a portfolio company.

Most venture capital funds have a fixed life of 10 years, with the possibility of a few years of extensions to allow for private companies still seeking liquidity. The investing cycle for most funds is generally three to five years, after which the focus is managing and making follow-on investments in an existing portfolio. This model was pioneered by successful funds in Silicon Valley through the 1980s to invest in technological trends broadly but only during their period of ascendance, and to cut exposure to management and marketing risks of any individual firm or its product.

In such a fund, the investors have a fixed commitment to the fund. There are substantial penalities for a Limited Partner (or investor) that fails to participate in a capital call.

In a typical venture capital fund, the general partners receive an annual management fee equal to 2% of the committed capital to the fund and 20% of the net profits (also known as "carried interest") of the fund; a so-called "two and 20" arrangement, comparable to the compensation arrangements for many hedge funds. Strong Limited Partner interest in top-tier venture firms has led to a general trend toward terms more favorable to the venture partnership, and many groups now have carried interest of 25-30% on their funds. Because a fund may run out of capital prior to the end of its life, larger VCs usually have several overlapping funds at the same time; this lets the larger firm keep specialists in all stages of the development of firms almost constantly engaged. Smaller firms tend to thrive or fail with their initial industry contacts; by the time the fund cashes out, an entirely-new generation of technologies and people is ascending, whom the general partners may not know well, and so it is prudent to reassess and shift industries or personnel rather than attempt to simply invest more in the industry or people the partners already know.

Venture capitalists are typically very selective in deciding what to invest in; as a rule of thumb, a fund may invest in as few as one in four hundred opportunities presented to it. Funds are most interested in ventures with exceptionally high growth potential, as only such opportunities are likely capable of providing the financial returns and successful exit event within the required timeframe (typically 3-7 years) that venture capitalists expect.

This need for high returns makes venture funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. That is most commonly the case for intangible assets such as software, and other intellectual property, whose value is unproven. In turn this explains why venture capital is most prevalent in the fast-growing technology and life sciences or biotechnology fields.

If a company does have the qualities venture capitalists seek such as a solid business plan, a good management team, investment and passion from the founders, a good potential to exit the investment before the end of their funding cycle, and target minimum returns in excess of 40% per year, it will find it easier to raise venture capital.

Because of the strict requirements venture capitalists have for potential investments, many entrepreneurs seek initial funding from angel investors, who may be more willing to invest in highly speculative opportunities, or may have a prior relationship with the entrepreneur.

Furthermore, many venture capital firms will only seriously evaluate an investment in a start-up otherwise unknown to them if the company can prove at least some of its claims about the technology and/or market potential for its product or services. To achieve this, or even just to avoid the dilutive effects of receiving funding before such claims are proven, many start-ups seek to self-finance until they reach a point where they can credibly approach outside capital providers such as VCs or angels.

There has been some debate since the dot com boom that a "funding gap" has developed between the friends and family investments typically in the $0 to $250,000 range and the amounts that most Venture Capital Funds prefer to invest between $1 to $2m. This funding gap may be accentuated by the fact that some successful Venture Capital funds have been drawn to raise ever-larger funds, requiring them to search for correspondingly larger investment opportunities. This 'gap' is often filled by angel investors as well as equity investment companies who specialize in investments in startups from the range of $250,000 to $1m. The National Venture Capital association estimates that the latter now invest more than $30 billion a year in the USA in contrast to the $20 billion a year invested by organized Venture Capital funds.

In industries where assets can be securitized effectively because they reliably generate future revenue streams or have a good potential for resale in case of foreclosure, businesses may more cheaply be able to raise debt to finance their growth. Good examples would include asset-intensive extractive industries such as mining, or manufacturing industries. Offshore funding is provided via specialist venture capital trusts which seek to utilise securitization in structuring hybrid multi market transactions via an SPV (special purpose vehicle): a corporate entity that is designed solely for the purpose of the financing.

Can venture capital have a direct impact for Latin America and the Caribbean development? The answer is yes, venture capital certainly can play a key role in business start-ups, existing small and medium enterprises (SME) and overall growth in developing economies. How? Being a source of job creation, facilitating access to finance for small and growing companies which otherwise would not qualify for receiving loans in a bank, and improving the corporate governance and accounting standards of the companies.

Start-up businesses usually receive some money from friends and families, but in most cases they face problems to find financing for the second stage of growth, which is venture capital, in a way that it becomes hard to get to the next level of growth that would lead to expansion. This means that they usually do not qualify to get a loan when they are start-ups since they cannot offer any collateral, so the growth cycle of a company can be impaired.

This trend is common in the economies of Latin America and the Caribbean, most of which highly depend on their SMEs -supposed to be the major driving force behind the country’s economic progress. Under the context of little developed financial systems, access to finance ends up constituting the main constraint to growth for start-ups and SMEs of the region.

The Multilateral Investment Fund (MIF) of the Inter American Development Bank, pioneering the industry in the region, as of now has injected capital in approximately 40 venture capital funds. When MIF invests in one of these funds, it seeks to attract other investors that may be new to the industry but can rely on MIF’s expertise in this area. This results in bringing much needed local and outside capital to the region.

Demonstrating that venture capital is a viable financial vehicle for Latin American and Caribbean countries, MIF has been supporting the development of new, local fund management companies, helping them acquire fund management skills according to international standards and developing an industry network. It also intends to transfer its know-how in due diligence to other investors, creating a pool of knowledge in the region, and shortening the learning curve for this industry.

No less important has been MIF’s active cooperation with the public and the private sector on regulatory changes to make the region’s markets more attractive to international and local private sector investors.

MIF recently approved a grant to the Latin American Venture Capital Association, which will work with other venture capital associations in the region to help them advocate for necessary changes in the legal and regulatory environment to improve the business climate.

US firms have traditionally been the biggest participants in venture deals, but non-US venture investment is growing.

Venture capitalists invested some $6.6 billion in 797 deals in U.S. during the third quarter of 2006, according to the MoneyTree Report by PricewaterhouseCoopers and the National Venture Capital Association based on data by Thomson Financial.

A recent National Venture Capital Association survey found that majority (69%) of venture capitalists predict that VC investments in U.S. will level between $20-29 billion in 2007.

Canada does have one fairly unique form of venture capital generation in its Labour Sponsored Investment Funds. These funds, also known as Labour Sponsored Venture Capital Corporations (LSVCC), are generally sponsored by labor unions and offer tax breaks from government to incite investors to purchase the funds.

Europe has a large and growing number of active venture firms. Capital raised in the region in 2005, including buy-out funds, exceeded €60mn, of which €12.6mn was specifically for venture investment. The European Venture Capital Association includes a list of active firms and other statistics. In 2006 the top three countries receiving the most venture capital investments were the United Kingdom (515 minority stakes sold for €1.78bn), France (195 deals worth €875m), and Germany (207 deals worth €428m).

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