The advantages and disadvantages of venture capital

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The advantages and disadvantages of venture capital
New business find it difficult to raise enough cash to run the company. (Phil Ashley/Lifesize/Getty Images)

The field of venture capitalism focuses investments on start up enterprises or small companies that hope to expand. The theory behind the strategy expects to increase return on investment by focusing on businesses during their growth phase rather than prioritising the security brought by investing in mature companies.

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Characteristics

Venture capital funds usually specialise in investments in new companies. Investors wishing to spread investments between established companies and start up companies would buy shares in the established companies on the stock exchange and then lend money to, or buy shares in, venture capital investment houses to get the growth element they require for their portfolio. Venture capital funds focus on start up companies or larger companies that are in trouble and need to be restructured. These types of investments offer the potential for long term profits, rather than short-term gain. Venture capitalists often expect some level of control of the company in return for their investment to ensure that the new company can benefit from the venture capitalists expertise and thus grow faster.

Capital

New companies, or companies that require restructuring, find it difficult to raise loans. Banks require business to show a track record of earning and only lend amounts of money that can be covered by past earning continuing at the same pace. Venture capitalists offer start up business a chance to raise money without the burden of debt. This brings advantages to the original owner of the company because he does not have to fund all of the company’s expansion from his own savings. It is also a benefit for the national economy because venture capital enables more companies to grow faster than they would be able to organically.

Risk

By spreading investments across a number of small companies, venture capital companies reduce the risk of losses. Their investors calculate that one or two of the companies in which the fund invests will fail, but higher growth among the remaining companies in the pool should more than compensate for these losses. Venture capital is a higher risk investment strategy than buying stocks and bonds. Investors expect a higher return on their investment to compensate for this risk. An investment by a venture capitalist reduces the risk incumbent on the founders of a company. The entrepreneur shares the risk of failure with the investor.

Control

Entrepreneurs are often reluctant to seek investment from venture capitalists. They see the company not only as their property, but an expression of their personality and a measure of their success. Venture capitalists are used to dealing with entrepreneurs and realise that they can be headstrong and make mistake. Venture capitalists, therefore, expect to have some form of control of the business decisions in the companies in which they invest.

Returns

When the business returns a profit, the founder will have to share that profit with the venture capitalist if he accepts their investment. The venture capitalist’s ultimate goal is to bring the company to the stock market and regain their investment by selling shares in the company. The entrepreneur may not want his company to go public and thus would not seek money from venture capitalists. The benefit of sharing profit with the venture capitalists should come from a larger profit with the investment than could have been achieved without it. Thus, the entrepreneur can make more profit long term despite losing a part of the share stock in the company.

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