Venture capital

Venture capital is the monetary contributions made by venture capitalists to
new and expanding companies. A venture capital fund is a partnership that
primarily invests the capital of third party investors in enterprises that
are typically too risky for ordinary bank loans. The monetary contributions
take the form of either equity participation, or a combination of equity
participation and debt obligation. That is, the venture capitalist becomes
part owner of the new venture. Most investments are structured as preferred
shares. Their investment criteria usually include a planned exit event (an
IPO or acquisition) within three to six years.

Role of the venture capitalist

The roles performed by a venture capitalist are:

     - directly providing funds for high risk, high return ventures
     - arranging additional financing from other sources
     - assessing and revising the proposed business model
     - reformulating the overall strategy
     - finding and hiring key managers
     - finding supportive service companies and other business contacts
     - firing existing managers where they think this is necessary
     - buying-out existing partners (owners) where they think this is necessary

Types of venture capital

A new venture may need several infusions from venture capitalists as the
business progresses.

   * The first round, referred to as seed capital, is obtained prior to
     company launch. It is for marketing research, concept testing, and
     alpha and beta testing.
   * The second round, referred to as start-up capital, is for hiring staff,
     renting office space, purchasing servers and other IT infrastructure,
     purchasing inventories, equiping the production system, and other
     activities involved in starting the business.
   * As sales (and production) levels increase, additional rounds could be
     needed to modify the site, re-equipt the production system, expand
     plant capacity, or purchase new facilities. These additional rounds are
     sometimes called second-stage financing.
   * Mezzanine financing is the final round of financing before going
     public. Once a companyÕs stock is publicly traded on a stock exchange,
     capital is raised by issuing and selling shares

Venture capital fund operations

Venture capitalists are very selective in deciding what to invest in. They
are only interested in ventures with high growth potential. Only ventures
with high growth potential are capable of providing the return that venture
capitalists expect. Because many businesses cannot create the growth
required to have an exit event within the required timeframe, venture
capital is not suitable for everyone. Venture capitalists usually expect to
be able to assign personnel to key management positions and also to obtain
one or more seats on the companyÕs board of directors.

Venture capitalists expect to be able to sell their stock, warrants,
options, convertibles, or other forms of equity in three to ten years: this
is referred to as harvesting. Venture capitalists know that not all their
investments will pay-off. The failure rate of investments can be high;
anywhere from 20 to 90% of the enterprises funded fail to return the
invested capital. Some venture capitalists try to mitigate this problem
through diversification. They invest in companies in different industries
and different countries so that the systematic risk of their total portfolio
is reduced. Others concentrate their investments in the industry that they
are familiar with. In either case, they work on the assumption that for
every ten investments they make, two will be failures, two will be
successful, and six will be marginally successful. They expect that the two
successes will pay for the time given to, and risk exposure of the other
eight. In good times, the funds that do succeed may offer returns of 300 to
1000% to investors.

Venture capital partners (also known as "venture capitalists" or "VCs") may
be former chief executives at firms similar to those which the partnership
funds. Investors in venture capital funds are typically large institutions
with large amounts of available capital, such as state and private pension
funds, university endowments, insurance companies and pooled investment vehicles.

Most venture capital funds have a life of ten years. Investors have a fixed
commitment to the fund that is "called down" by the VCs over time as the
fund makes its investments. In a typical venture capital fund, the VCs
receive an annual "management fee" equal to 2% of the committed capital to
the fund and 20% of the net profits of the fund. Because a fund may run out
of capital prior to the end of its life, VCs may have several overlapping
funds at the same time.

Historical developments

The late 1990s were a boom time for the globally-renowned VC firms on Sand
Hill Road in the San Francisco, California area. The NASDAQ crash and
technology slump that started in March 2000, and the resulting losses on
overvalued, non-performing startups, has shaken VC funds deeply. In 2003,
many VCs are focussed on writing off companies they funded just a few years
ago. At the same time, venture capital investors are seeking to reduce the
commitments they have made to venture capital funds. As of mid-2003
conventional wisdom is that the venture capital industry will shrink to
about half its present capacity in the next few years.

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