Venture Capital: a Simple Explanation about How to Finance your Startup

21 August, 2013 — 6 Comments

Marco Polo, first entrepreneur who raised venture capital

Marco Polo, the Venetian merchant, who arrived to China in the thirteenth century, was one of the first entrepreneurs who got venture capital. He convinced several wealthy Venetians to finance his commercial expedition to Asia. Marco Polo promised that he would share his profits of this risky venture with them. These funders were a kind of precursors of the current venture capital, which main characteristics I describe below in a simplified form:

  • A venture capital fund has a large amount of money at its disposal to invest in some startups. This could be millions of euros.
  • The Fund invests its money in the company, which is looking for financing. So the Fund becomes a shareholder in the startup. The startup is then called “investee” company.
  • The Fund usually owns a large share, but not more than 50%. For this reason the Fund ask the entrepreneurs to sign a shareholders agreement. This regulates the investment and disinvestment conditions, as well as a clause that doesn’t allow entrepreneurs to make strategic decisions without the Fund’s permission.
  • The Fund nominates its own board member. This professional defends the interest of the Fund and provides his experience to the entrepreneurs about strategic decisions.
  • The Fund holds its investment during some years, at the end of which it sells its shares to another company, another investor or to the other shareholders (the original entrepreneurs).
  • The objective of the Fund is to earn money when it sell its shares. This is the business of venture capital funds!
  • Venture capital funds takes the risk that they will lose some investments. This happens very often since a high percentage of startups fail after a few years. Entrepreneurs do not offer other guarantees. In view of the high risk involve, the Fund expects that the value of its investment will multiply several times.

An example:

A venture capital fund invests in 10 startups. It plans to sell its equity after five years. What happens to its startups?

  • Five of them have ceased to exist and the Fund has lost all the money it invested in the startups.
  • Three other companies have had a slight increase, much lower than expected and the Fund recovers more or less the same little money it invest in them.
  • Two companies have met the expectations and they have grown a lot. The Fund has sold its shares in these companies at a price 5 times higher than the money it invested.

The benefit in two companies should allow venture capital fund to cover losses of the five companies that have closed, to cover its own operating costs during five years and eventually get some net profit to distribute among its shareholders, those who which are the initial capital contributed to the Fund.

To learn more:

Video about how venture capital works (2 minutes):

If you can’t see this video on your movil, please try here (Youtube link)

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