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Among the various financing options entrepreneurs can turn to when starting a new company is venture capital. Venture capital is money that is given to help build new startup firms that often are considered to have both high-growth and high-risk potential.

Entrepreneurs often turn to venture capitalists for money because their company is so new, unproven and risky that more traditional forms of financing, such as through banks, aren’t readily available. Unlike other forms of financing where entrepreneurs are only required to pay back the loan amount plus interest, venture capital investments most commonly come in exchange for ownership shares in the company to ensure they have a say in its future direction.

Not all venture capital investments take place when a company is first being founded. Venture capitalists can provide funding throughout the various stages of a company’s progression. Research from the National Venture Capital Association revealed that in 2010, venture capitalists invested approximately $22 billion into nearly 2,749 companies, including 1,000 of which received funding for the first time.

Where Does Venture Capital Come From?

Venture capital funds come from venture capital firms, which are comprised of professional investors who understand the intricacies of financing and building companies. The money that venture capital firms invest comes from a variety of sources, including private and public pension funds, endowment funds, foundations, corporations and wealthy individuals, both domestic and foreign. Those who invest money in venture capital funds are considered limited partners; while the venture capitalists are the general partners charged with managing the fund and working with the individual companies. The general partners take a very active role in working with the company’s founders and executives to ensure the company is growing in a profitable way.

In exchange for their funding, venture capitalists expect a high return on their investment as well as shares of the company. This means the relationship between the two parties can be lengthy. Instead of working to pay back the loan immediately, the venture capitalists typically work with the company five to 10 years before any money is repaid. At the end of the investment, venture capitalists will sell their shares of the company back to the owners, or through an initial public offering, for what they hope is significantly more than they initially put in. The most recent available statistics found more than 450 active U.S. venture capital firms that had each invested at least $5 million. The firms had an average fund size of nearly $150 million.

Venture Capital Helps Fill a Void

Venture money is not long-term money. The idea is to invest in a company’s balance sheet and infrastructure until it reaches a sufficient size and credibility so that it can be sold to a corporation or so that the public-equity markets can provide liquidity. Basically, the venture capitalist typically buys a stake in an entrepreneur’s idea, nurtures it for a short period of time, and then exits with the help of an investment banker.

Venture capital’s niche exists because of the structure and rules of capital markets. Someone with a business idea often has no other institution to turn to besides a bank. Laws limit the interest banks can charge on loans—and the risks inherent in start-ups usually justify higher rates than allowed by law. Therefore bankers will only finance a new business to the extent that there are hard assets against it to secure the debt. However, in today’s information-based economy, many start-ups have few hard assets.

Venture capital fills the void between sources of funds for innovation and traditional, lower-cost sources of capital available. Filling that void successfully requires the venture capital industry to provide a sufficient return on capital to attract private equity funds, attractive returns for its own participants, and sufficient upside potential to entrepreneurs to attract high-quality ideas that will generate high returns. Simply, the challenge is to earn a consistently high return on investments in inherently risky business ventures.

Venture Capital vs. Angel Investors

Last week, we published an article about angel investing. Up until this point, you may be quick to point out that angel investors and venture capital are practically two identical ways to finance your business. However, there are a few fundamental differences between the two.

While they both provide capital to startup companies, the biggest distinction is that venture capital comes from a firm or a business, while angel investments come from individuals. A second key difference is that while new startups typically receive millions of dollars in venture capital, angel investors typically never put more than $1 million into a project.

Another difference is that venture capitalists will generally invest in any startup they feel has the potential to make them money, while angel investors generally like to make investments in firms that work in industries they are personally familiar with. In addition, angel investors don’t always require a hands-on role in the running of the company, as venture capitalists do.

Is It a Viable Option for Your Business?

Although the idea of venture capital seems promising, just like angel investing, it’s not necessarily the smartest way to fund your start-up. Essentially, the bigger the stake you give away in the early stages of your startup’s life, the less of the company you will own. If you are motivated by making your own decisions, keeping your baby your own, and reaping all the benefits from a company you paid for in hard work, sweat, and tears hold, then use a financing vehicle that won’t require giving up equity in your company. And, as always, our team is here to work with you and help you choose the right funding solution for your business financing needs.