Low venture capital interest rates serve as fuel for venture capital investments. However, low interest rates also discourage venture capitalists from putting their money into riskier startups that are in foreign countries, less popular industries, or are considered young. Generally, venture capital firms will invest their money after comparing the profits that they will achieve versus the profits that are currently available in the market. The relationship between risk-taking and interest rates will change based on each individual investor's risk appetite.

Venture Capital

Capital flowing into a company as an investment, usually prior to the initial public offering (IPO), is usually considered venture capital. The funds may be managed by an individual or a group that is referred to as venture capitalists. The investments made by venture capitalists (VCs) will normally require a:

  • Large amount of ownership in the company.
  • High return on investment.

Advantage of Venture Capitalists

For many entrepreneurs, venture capitalism represents the most appealing and glamorous type of financing. VCs may provide advice, prestigiousness, and large amounts of money. Also, VCs help boost entrepreneurialism in the overall economy.

How Do Venture Capitalists Generally Work?

Many young companies depend on VCs to help finance their businesses through loans or equity investments. Often the loans are very expensive, charging up to 25 percent. Generally, because VCs are taking a large risk on a young company, they demand high rates of return. An annual rate of return of 30 to 50 percent on an equity investment is not unheard of.

Unlike banks, VCs will usually take equity positions in young companies. In other words, businesses don't have to take on debt and pay principal and interest installments. Rather, they only pay a portion of the owner's equity in exchange for the backing by the VC. In reality, many VCs are able to take control over the company and force out the founders. This is why they are sometimes referred to as "vulture capitalists."

What Are the Features of Companies That Venture Capitalists Usually Invest In?

VCs will usually invest in businesses that they anticipate will be sold to larger firms or the public in the near future. Businesses that a VC would most likely consider investing in typically have the following attributes:

  • The potential that the business will be bought out by a larger organization or be taken public in an initial public offering.
  • A strong management team.
  • Proprietary rights held over new technology or an influential position in an emerging economy.
  • An accelerated or steady growth in sales.

Additionally, VCs often characterize their investments by the life cycle of the business. The business financing life cycle consists of:

  • Seed.
  • Second stage.
  • Bridge.
  • Leveraged buyout.

Venture Debt: A Capital Idea for Startups

Businesses that have poor cash flow or lack the assets for traditional financing are often interested in debt financing backed by VCs. Debt financing or venture debt is usually structured as a three-year term loan, including warrants, a security that entitles the holder to buy the underlying stock of the issuing company at a fixed price until the expiry date. In most cases, venture debt is secured by a company's assets. When structured correctly, venture debt is considered less expensive than equity financing.

Advantages of Venture Debt

The main advantages to taking on venture debt rather than equity-based debt are:

  • Debt is almost always less expensive than equity.
  • The cost of equity will shift based on various valuations.
  • VCs will leverage the available equity to offer more reasonable loan terms when compared to traditional lenders.
  • Lenders of venture debt will never control board seats.
  • The ability to achieve additional progress ahead of future valuations.
  • The likelihood that the business will be solvent in the future increases.
  • The dilution of ownership in the company will not occur.

The value received by young firms raising venture debt instead of equity-based financing is best understood in the incremental ownership that is retained in the business during the early stages of growth. Consider $100 of venture debt with 7 percent warrant coverage and principal and interest repayment terms such that $30 will be paid prior to the beginning of the next round. The business has gained the use of $70 worth of capital for about $5 of dilution, reducing dilution by about 95 percent.

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