Venture capital is financing given to start-up businesses that have high growth potential. These investments tend to have a high level of risk for investors, which is offset by the prospect of high returns. Given the significant risk of loss associated with venture capital investments, the investors in venture capital funds tend to be high net worth individuals who can afford to sustain significant losses. Offsetting the possibility of these losses is the chance to earn an outsized return on a few of the investments made.
There are several stages in the initial growth of a business at which venture capital can be invested. Seed money is a small amount of initial capital that is invested with the intent of proving a business concept. Once products are in development and market share is being expanded, the amount of venture capital invested is substantially larger, typically over the course of several rounds of financing. Investors recoup their investments either by selling their shares in the business during an initial public offering, or through sale of the business to a larger organization.
A potential downside for investees is that venture capital investors typically want one or more board seats, and may force changes in the management structure of the business. Also, venture capital can only be obtained in exchange for a significant share of the equity of the business, so the founders of the firm may find that their eventual earnings from selling the entity are lower than expected. Offsetting these problems are the benefits of early funding that might not be available from other sources, as well as management advice from the venture capital firm and use of its connections with other firms in the industry.
It can be quite difficult to obtain venture capital funding, since venture capitalists tend to be quite picky in selecting investees. They are looking for an experienced management team, a unique business plan, and a prospect for rapid growth. Further, they will only invest in industries where they already have a significant level of expertise, perhaps due to prior investments in the same areas.