Updated: Oct 23, 2020
A major portion if not all the money invested by VC firms is bound to go into infrastructure required to conduct and also grow the business such as manufacturing marketing and also sales and maintain the balance sheets.
Venture funding is not meant to be long term funding. The central idea in such funding is to insert investment in an organization’s balance sheet and also infrastructure till a pre-determined size and market credibility is reached so that is can be sold to a larger corporation or so public-equity markets can get into the action and generate liquidity. Essentially, a venture Capitalist would purchase a stake in an entrepreneurial idea and nurture it for a short duration ending in an exit with the aid of an investment banker. Putting things simply, the big challenge here remains to progressively earn a superior return on investments in what are inherently risky business ventures.
How VC Funding Works?
It is a widely held belief that VC firms tend to invest in what they fin to be great people and great ideas. But in practice it all comes down to VC firms investing in great industries which do well irrespective of existing competition and the current market.
VC firms and capitalists tend to focus on the central part of the traditional industry S-curve. They tend to stay away from the early stages, when the technologies haven’t been perfected and the market needs are still developing. They also stay away from later stages when competitive phases in the market arise and growth rates slow down without much that can be done to change things. Consider the disk drive industry. In 1983, more than 40 venture-funded companies and more than 80 others existed. By late 1984, the industry market value had plunged from $5.4 billion to $1.4 billion. Today only five major players remain.
The adolescent period of accelerating growth characterized by especially high growth, referring to the initial growth phase of the company, it becomes a major challenge to set apart the eventual gainers from the losers because initially both types of enterprise will have their growth curves and also financial performance look the same. At the initial stage such as this, companies are trying to deliver products as best as possible to a market which has displayed a need for the said product. At this stage the VC has the challenge to identifying management which can successfully execute tasks to meet market demand.
Even though selecting the wrong industry or betting on a technology risk in an unproven market segment is something VCs avoid, there are exceptions to this rule which tend to involve “concept” stocks. These are companies that hold great potential but take a really long time to succeed. A great example for this occurrence is genetic engineering companies which act as a case study, proving this concept. In this particular case, the VC firm’s challenge is to recognize entrepreneurs who can advance key technologies to a certain stage such as approval from national and international health agencies that certify the process or product that has been invented.
Here comes the key part of the VC funding process. Once the VC firm has funded the portfolio company and time has elapsed, the VC’s will have exit the company and the industry possibly before it reaches its peak, which will ensure the VC’s can harvest the highest profit or ROI at a relatively lower risk. Smart, and experienced VC’s work in a secure niche where conventional and low-cost financing is mostly unavailable. Provided things work out, high rewards can be paid to management teams which are successful and also institutional investment will be accessible to provide liquidity in a comparatively short time period.
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