Venture Capital Investment Characteristics

Venture Capital Investment Characteristics

Venture capital investments almost always involve investments in assets which cannot be liquidated immediately and the return on which is highly uncertain. Venture capital investments also have several significant characteristics.

  • The investment process— The investment process of venture capitalists is longer compared to most other investors and includes a close scrutiny of the product, the technology, the market, and the management.

  • Involvement in the company after the investment— Venture capital investors, as money managers, are usually much more actively involved in the management of their portfolio firms than most investors in capital markets.

  • The investment objective— A venture capital investment is made with the declared intention of exiting it within a fixed period of time.

  • The types of companies in which the capital is invested— Venture capital investments are usually made by purchasing the equity (either ordinary shares or preferred shares which are convertible into ordinary shares) of companies in the private sector, as distinguished from buying and selling traded securities.

  • The risk of and return on the investment— In venture capital investments, the chances of an investment losing value or being lost altogether are high. Therefore, investors in venture capital funds expect a significant compensation for the risk involved in their investment. Where investments in startups are concerned, the risks involved in the investment are typically higher than in investments in more marketable assets. First, an infant company is more exposed to changes in the market and to recessions. It does not usually generate revenues which enable it to survive on its own resources, and it is therefore more dependent on raising external capital, the availability of which depends to a great extent on the condition of the capital market. In addition, since the company places most of its hope in products not yet fully functional, there is a risk that the products will not function or sell as anticipated, that the young and inexperienced management will not succeed in driving the company forward, or that another competitor will overtake the company in conquering the relevant market (for a discussion of the IRR required in investments in startups, see the section on the discount rate used by VCs).

  • The human factor— A venture capitalist will prefer, more than in other types of investments, to invest in a company which has a good management team in which he believes, than in a company with a more promising product and target market but with a management team in which he has no faith. A weak management team could cause the entire investment to be lost or require the investor to dedicate much time to managing and monitoring the investment. Due to the illiquidity of investments of this type, an exit is usually not readily available, and the investor must therefore carefully consider whether he is prepared to join the company for several years.

Venture Capital Funds and Their Investors

Venture capital funds are intermediaries between investors and companies. On the one hand, funds provide professional screening services and scrutinize promising investments as well as provide a means to invest in portfolios of ventures, and on the other hand, funds amass capital and attract a large number of investors to invest in companies. Funds also provide investors with management, reporting, and monitoring services with respect to the portfolio companies and provide portfolio companies with added value (see the section on the added value of venture capital funds). From these respects, venture capital funds improve the investment process and reduce its cost and the investors' exposure to risk, in consideration for which they are compensated by the investors in the fund with annual management fees and a portion of the future profits.

Private equity funds in general, and venture capital funds in particular, give investors an alternative to investing in traded securities and debentures. They offer investors a diversified portfolio with the chance of increasing the risk adjusted return on their investment (see the discussion on investment theory in the section on the venture capital method). Venture capital funds are an efficient platform for these alternative investments, and they remove the need for establishing an in-house department for this purpose. However, many large technology companies have in recent years established investment arms which focus on identifying investment opportunities which are close to their fields of activity. For instance, Nokia, Intel, Time Warner-AOL, and many others also make considerable direct investments in startups, besides their investments in venture capital funds.

Venture capital funds use various control tools to provide their investors with monitoring and supervision services. These services are founded on the experience of the fund managers, as well as their ability to supervise portfolio companies by determining procedures and targets for them. Naturally, the larger the information gaps between the investors and the managers of the company, the more valuable are the controlling entities. Since venture capital funds provide investors with the means of control, they understandably focus on areas in which there are large information gaps, such as in many areas in technology which require a high level of expertise, and in companies in the early stages of development (see the section on the means by which venture capital funds oversee their investments for a discussion of funds' control tools).