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How Venture Capital Funds Work

Professional Venture Capital funds provide finance for companies at various stages of development, seed capital, start up capital, and capital for expansion as well as funds for management buy-outs.  In addition to differentiating themselves as to the types of transactions they are interested in, funds can also be categorised by sector such as technology, healthcare etc. and preferred deal size.

Venture Capital funds are usually set up as partnerships which invest the money of their limited partners.  The partners in a Venture Capital Fund are usually financial institutions such as pension funds, banks, insurance companies and sometimes other venture capital funds.

When a Venture Capital firm raises money from these sources, they put the money into a fund.  The amount raised for a specific fund will be predetermined and this sum will then be invested for a defined time span, usually 3-5 years.  Investors in the Venture Capital funds have specific requirements in relation to the returns they require and therefore the venture capitalists managing a fund must evaluate its potential investments in order to provide the required return.

As the return on the investment is critical, Venture Capitalists always invest with specific criteria in mind.  Some Funds invest, for example, in deals between £2-5 million per venture over a 3-5 year period and look for companies with market potential of £50-100 million.

Venture Capital Funds typically invest only in small numbers of companies and therefore each investment must be screened carefully.  VC’s require a 30-40% or more annual return on their investment and look for a total return of 5-20 times their initial investment.

In order to maximise their return, many VC’s wish to actively participate in managing their investment.  Rather than investing cash and leaving companies to manage their own affairs VC’s will often become involved as advisers to management and require a seat on the company’s Board of Directors.

Given the hands on approach of many VC’s, it is important for a company to perform due diligence on any proposed investor in order to ensure that the maximum benefit is attained by the company.  Issues to consider are as follows:-

-Does the VC have experience in your sector?
–  Has the VC invested in any of your competitors?
-How active/passive is the VC?
-Who will deal with the company post-deal?
-Does the VC have the ability to invest further funds in the company should additional sums be required?
– Can the VC provide useful business contacts for the development of business partnerships?

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