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What Investment Bankers Should Know about Venture Capital

In the investment banking world, venture capital is money provided to startup companies and young firms that don't yet have a track record that would allow them to tap the more traditional sources of funds, such as bank loans or initial public offerings (IPOs). Anyone who has watched the reality TV show Shark Tank is getting a glimpse into the world of venture capital financing.

Essentially, venture capital is the place where the entrepreneur with a great idea and a solid business plan gets seed capital or working capital from sophisticated investors who are looking for the next big thing like Microsoft or Cisco Systems — two companies that were financed by venture capital investment.

Venture capital firms are generally structured as partnerships. The limited partners are the investors and provide the capital. The general partner manages the investments — essentially figuring out which companies to invest in.

Unlike traditional stocks and bonds, investment in venture capital is very illiquid — the commitment of funds is generally for a fairly long time period (generally five to ten years) and cannot be readily bought and sold. In contrast to investing in traditional stocks and bonds, venture capitalists typically take a very large ownership position in a company and play an active role by providing management expertise and closely monitoring progress.

The fee structure in venture capital is similar to that in the hedge fund industry. The two and twenty compensation scheme is standard fare in the venture capital world. So, for the investment in a venture capital fund to prove to be profitable, the underlying investments must collectively perform at a high level to provide both the return to the investor and cover the management fees.

Venture capital investing is a risky endeavor — the average investment proves to be unprofitable. Most young firms simply don't make it and only a select few make it big. So, successful venture capital investing is a numbers game. To justify the risks taken, the returns expected by investors are much larger than those on traditional investments that involve less risk of failure.

Many venture capital investors target returns of over 30 percent per year. To hit such a lofty target and to mitigate their risk, venture capital funds often invest in a large number of young firms. If a venture capital investor provides financing to ten firms and only one of them is successful — but that one is wildly successful — the investment can be a major success.

Success for the individual firm that receives venture capital financing — and for the venture capitalist that provided the financing — is realized when the firm goes public via an IPO or is sold to another company for a huge price. That's the ultimate dream of both the entrepreneur and the venture capitalist.

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