When startups need funding, venture capital is one option they might consider. Getting funding from a VC firm can offer certain advantages to new businesses that may not be able to get approved for traditional loans. Thanks to the rise of crowdfunding, it’s now becoming decidedly more mainstream.
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Venture Capital Explained
Venture capital is a type of private equity investment. A venture capital firm or individual investor extends funding to startups that can grow over the long-term. The emphasis is primarily on new companies that are looking for seed funding to launch or scale operations, rather than established businesses.
The idea behind venture capital is that the firms or individuals who invest in them may see a sizable payoff down the line if the company succeeds. Venture capital isn’t a loan; startups don’t make payments back to the venture capital firm monthly. Instead, venture capitalists are repaid for their investments in the form of equity shares in the company.
That means venture capital can have a longer time frame to generate a return. That’s especially true compared to investing in a stock or mutual fund. Essentially, the firm or investor may only realize a financial benefit once the startup goes public and its shares begin trading on the stock market. Also, if the company is acquired by another company at a profit.
Startups that work with venture capitalists may transfer of equity to investors for access to capital. Startup loans or business credit cards may be funding options for new businesses. However, they usually come with borrowing cap that’s in the thousands or tens of thousands of dollars. Venture capital, on the other hand, could provide millions of dollars in seed funding for startups immediately. Meanwhile, it doesn’t require them to meet credit score or revenue requirements the way a business loan would.
The Pros of Venture Capital Investing
The main advantage of investing in venture capital is the potential to reap big financial rewards if the company or companies you’ve invested in do well. If a startup has a highly successful initial public offering, for example, the value of your equity share in the company could skyrocket overnight. If you then sell your shares in the company, the end result could be a substantial profit and return on your initial capital investment.
Venture capital investing is also an opportunity for many investors to give back, similar to angel investing. It’s a chance for firms and individuals to pay it forward in a sense and support businesses or industries that are meaningful to them in some way. If a venture capital investment includes an exchange of equity, the firm or individual that’s doing the investing could also have the opportunity to play a part in the company’s decision-making and management.
Drawbacks of Venture Capital Investing
The chief downside of investing in venture capital is that it can be exceptionally risky. Venture capital firms typically have the resources and tools available to research startups and are selective when deciding which companies to fund. They also have the expertise and knowledge to get a feel for which companies are likely to succeed and which ones aren’t. But when that turns out to be wrong and a startup tanks, the result could be a major financial loss for the VC firm.
That’s why VC firms often invest in multiple startups at once. They spread investment assets across multiple companies to diversify and ideally minimize risk. If one or more of the startups the firm backs fail, then there are other companies that can hopefully balance out those losses as they grow. Even one successful venture capital investment could outweigh five failed ones if the overall return is high enough.
How to Invest in Venture Capital
Traditionally, venture capital has been the domain of investment banks and private wealth management firms, though there are individual high net worth investors who fund VC opportunities. Over the last few years, venture capital has become more accessible to the everyday investor through crowdfunding platforms.
Crowdfunding sites offer an opportunity to pool your money with other investors to back startups. There are several advantages, both for startups and investors. On the startup side, crowdfunding platforms can make it easier to access venture capital. In a typical VC arrangement, startups have to pitch firms which can be a time-consuming and frustrating process. Crowdfunding eliminates that hurdle.
For investors, crowdfunding makes it possible to invest like a VC firm without all the standard barriers to entry. While a venture capital firm might be able to invest $5 million in a new company, you might only have $5,000 to invest. But by pooling your money together with other investors, you can still grab a slice of the pie so to speak and invest in up-and-coming companies.
There are, however, a few things to keep in mind if you’re considering venture capital investing through a crowdfunding platform. As you compare platforms, consider the following:
- Whether the platform is open to both accredited and nonaccredited investors.
- What fees the platform charges to invest.
- The minimum investment required.
- How soon you can expect to see a return on your investment.
- How returns are realized, (i.e. dividend payouts).
Also, consider the timeline involved when investing in venture capital. It can take years for a startup to get its bearings and become competitive in the marketplace. And even that’s no guarantee that it will be profitable. So consider how long you’re comfortable typing up money in a venture capital investment before diving in.
Bottom Line
Venture capital can be an attractive funding option for startups bypassing traditional business financing options. As an investment, venture capital could offer big returns. ut that usually involves taking a bigger risk with your money. Crowdfunding platforms can be somewhat more cost-efficient.
Investment Tips
- Consider talking to your financial advisor about VC investing. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Crowdfunding isn’t just for venture capital investments. Real estate crowdfunding, for example, is another way to invest by pooling your money. The difference is that instead of investing in startups, you’re investing in property. This could be yet another way to diversify your portfolio and increase returns if you lack exposure to real estate.
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