Venture capital plays a unique role in financing innovative projects with a high degree of risk. For new companies or those with a short operating history, venture capital is often a popular, and sometimes necessary, avenue to attract funding.
More specifically, there are three primary types of venture financing: investments made at:
1. The early (seed) stage.
2. The expansion stage, as a form of financial assistance to companies utilizing IPO as their main business strategy.
3. The acquisition or buyout stage, often involving leveraged finance.
In the vast majority of cases, venture capital firms provide funding at early stages for rapidly growing firms with high growth potential. The reason is that such startups would otherwise be unable to secure the necessary level of investment to realize their ideas, given that they do not yet have access to traditional sources of financing (such as bank loans and other debt instruments). In addition to providing capital, investors often take seats on the board of directors and provide operational and strategic guidance for their investments.
Firms are selected based on criteria that provide venture capital companies with the opportunity to rapidly increase their investments and exit within established timeframes. This exit process, known as the "harvest strategy," typically occurs over a period of 3-10 years through an initial public offering (IPO) or through merger or sale of the company.
An important aspect of the investment process is deciding when to divest from investments, that is, the duration of the investment. Generally, venture capital firms will continue to invest in a firm as long as the marginal added value they provide exceeds the marginal costs of maintaining the investment.
The due diligence stage varies based on the nature of the business proposal. This process includes addressing issues related to customer recommendations, product evaluations, and business strategies, as well as interviewing management and other similar exchanges of information during this period.
Consequently, the duration of venture investments will vary based on the anticipated strategic advantage. Specifically, where the added value provided by the venture investor, all else being equal, is higher, the duration of the investment will be longer.
