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Venture Capital

What factors lie at the basis for Venture Capital investment decisions

Written by U. Hellquist, M. Kraljevic

Paper category

Master Thesis

Subject

Business Administration>Entrepreneurship

Year

2006

Abstract

Master Thesis: Venture capitalists Due to the high failure rate of small companies, small companies have always had problems in raising funds from investors; the overall failure rate in the first three years of operation is 50%. However, there are many sources of funding, such as local/central government, European community grants, company suppliers, customers, clearing banks, commercial banks, loans from family/friends, and venture capital companies (Mckeon, 1994). The most common way to finance a startup is to get a loan from a friend, family member or bank. However, in recent years, venture capital financing has gained recognition as a source of funding for small startups (Connect Sverige, 2005). Start-ups in the early stages of development have strong funding needs, and venture capitalists welcome such investments. This is why venture capital financing plays and still plays a catalytic role in the entrepreneurial process and is regarded by many as its core reason (Bygrave & Timmons, 1992). Why do venture capitalists welcome these types of investments when most other investors exit? A simple way to explain it is that start-up companies exhibit high risks and high returns (Cook, 1996). Therefore, venture capital companies are the type of investors who are willing to accept these risks to obtain high returns (Hill & Power, 2001). They see great opportunities for capital gains by supporting these types of companies (Cooke, 1996). They are basically gambling on the rapid growth of their business, hoping to obtain a return on investment of 300-500% within 3 to 5 years (Ryan & Hiduke, 2003). Generally speaking, venture capitalists are investors who seek higher value growth than traditional investments or placements. If the rate of return on capital is higher than expected on investments such as the stock market, venture capital firms will be attracted to invest in start-ups (Connect Sverige, 2005). Therefore, venture capital is most suitable for companies that can show rapid growth (Cooke, 1996). Another reason venture capitalists want to invest in companies that can show rapid growth is that investment is often time-bound. This means that the goal of venture capital companies is to dispose of their investments and exit the company within a given time frame, that is, cash out (Connect Sverige, 2005). The typical timetable for venture capital investment is 4 to 7 years (Cooke, 1996; Camp, 2002). However, this is not just a capital investment (Connect Sverige, 2005). In addition to obtaining funding from venture capital firms, startups will also benefit from other factors, far beyond the currency. Venture capital companies provide start-ups with the experience of establishing companies, helping companies establish distribution channels and assemble an appropriate management team if necessary. 2.2 The Venture Capital Process There are some venture capital investments that have achieved incredible success, such as Apple Computer, Tandem, and Genetech. These investments achieved a return of more than 100 times at the time of listing. There are also amazing failures. Venture capitalists are reluctant to write down cases of losses and continue to invest a lot of money. There is evidence that the possibility of venture capital failure is greater than impossible. Among the more than 400 venture capital companies in the United States, only the top 50 or so are very successful. Needless to say, venture capital is not an easy task (Wu, 1988). Venture capital companies have recognized the instability of their investments, so they spend time collecting as much information as possible to make better decisions. From top to bottom, the investment process of a venture capital company starts with deciding whether to invest. They basically have only two options; either investors do not invest. This completely simple way of thinking is shown in the figure below and the resulting results; the more desirable result is obviously to invest in a successful business that provides venture capitalists with good returns and capital gains. On the other hand, the worst-case scenario is that there is a failed business that has no return. Venture capital companies will basically lose all or at least most of their investment funds. Therefore, venture capitalists must be very careful to avoid this trap. How do venture capital companies make decisions about their investments? Fichera (2001) pointed out that venture capitalists follow a specific process called the venture capital process when making decisions. The VC process is as follows; the first step in the venture capital process is to screen the business plan, then to meet with the entrepreneur’s individual, and then conduct due diligence (Fichera, 2001). Due diligence is the process of verifying facts about the company under investigation. It can include interviews with key personnel, suppliers, customers, competitors, a comprehensive review of related documents, factory tours, etc. The goal is to fully understand the company and its past, present and future from all possible angles. (Wu, 1988). This is a long process and usually takes several months to complete (Zacharakis & Meyer, 1998). To obtain funding, new companies must pass preliminary screening; review of business plans. 2.2.1 Business plan It can generally be said that a business plan serves internal and external purposes. Internally, it provides a way for companies to develop their ideas and plans for business development (Siegel et al., 1993; Gumpert, 2002). Visualizing and analyzing future plans can help companies allocate resources correctly, deal with unexpected and complex situations, and make good business decisions. Read Less