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Venture capital (VC) is capital used by private equity funds to support the creation and growth of businesses; it is characterized by a tradeoff between high risk and high rates of return. Most VC has been invested in technology- oriented companies and projects. Because it is independent and professionally managed, VC is a crucial equity type of external financing for privately held companies that seek to grow rapidly. As a result, VC investments play a critical role in economic development.
Newly created firms that are expected to grow quickly into big companies often do not have sufficient funds to finance their projects and thus need outside financing. These firms are subject to potential capital constraints; that is, they have difficulty receiving bank loans and other types of standard financing because of a limited track record and uncertain future prospects. VC is a professionally managed pool of money raised for the specific purpose of making equity investments in such companies. In addition to providing new capital during critical stages of development, professional management adds value to expansion through screening, monitoring, and aiding in decision-making. A typical VC firm receives many proposals per year, but only approves a very small percentage.
The first formal private equity fund was formed in 1946 in Boston to provide financing to several companies that had developed new technologies during World War II (1939-1945). The first VC limited partnership was formed in 1958. Even though several other VC companies were established later on, the total average annual VC investment did not exceed a few hundred million dollars until the end of the 1970s. During the 1980s, VC firms provided capital to the most successful high-technology companies, such as Cisco Systems and Microsoft. Since then, the private equity industry has been experiencing tremendous growth in the United States, both in terms of the amount of capital invested and in terms of returns. VC market growth also spread abroad, first to the U.K. and then to continental Europe and beyond. Differences in the nature of financial markets from country to country are the main reasons for the varying maturity of VC markets. For instance, there is a clear institutional separation between investment banks and the VC industry in the United States, but in countries with relatively young financial markets, the functions of VC firms are often performed by major investment banks as well as private equity partners. Whereas VC firms provide funds to firms at early stages of their development in the United States, in Europe and in developing countries VC companies prefer firms that have already developed and started marketing their products.
The supply of VC is determined by investors’ willingness to provide funds to venture firms. This willingness depends on the expected rate of return on investments. High-tech companies with the potential to grow rapidly are also highly risky investments. VC firms that become major equity owners in such new firms are only willing to finance high-reward investment proposals because they also have responsibilities to several other funding sources, such as individual investors, investment bankers, subsidiaries of banks, and other corporations. In order to make money on their investments, a VC fund needs to turn the illiquid stakes in private companies into realized return, for example by taking a company public. The most profitable exit opportunity for VC firms is an initial public offering (IPO). In an IPO, the VC fund assists the company in issuing shares to the public for the first time. The exit is an important aspect of the VC business because investors in a VC need a way to evaluate the performance of VC funds in order to decide whether to provide further capital. On the stock exchange, the success of existing strategy is demonstrated by lower underpricing (the difference between offer price and first-day trading price) and by high long-term performance (measured against certain benchmark investments). Empirical research shows that VC backing reduces the degree of IPO underpricing, and that the long-term stock returns (up to five years) of companies backed by VC funds are substantially better than those of companies without VC.
Bibliography:
- Barry, Christopher B., Chris J. Muscarella, John W. Peavy, and Michael R. Vetsuypens. 1990. The Role of Venture Capital in the Creation of Public Companies: Evidence from the Going-Public Process. Journal of Financial Economics 27 (2):447–472.
- Bygrave, William D., and Jeffry A. Timmons. 1992. Venture Capital at the Crossroads. Boston: Harvard Business School Press.
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