Why do venture capitalists invest

One myth is that venture capitalists invest in good people and good ideas. The reality is that they invest in good industries—that is, industries that are more competitively forgiving than the market as a whole. More recently, the flow of capital has shifted rapidly from genetic engineering, specialty retailing, and computer hardware to CD-ROMs, multimedia, telecommunications, and software companies. The myth is that venture capitalists invest in good people and good ideas. The reality is that they invest in good industries.

In effect, venture capitalists focus on the middle part of the classic industry S-curve. They avoid both the early stages, when technologies are uncertain and market needs are unknown, and the later stages, when competitive shakeouts and consolidations are inevitable and growth rates slow dramatically. Consider the disk drive industry.

In , more than 40 venture-funded companies and more than 80 others existed. Today only five major players remain. Growing within high-growth segments is a lot easier than doing so in low-, no-, or negative-growth ones, as every businessperson knows. In other words, regardless of the talent or charisma of individual entrepreneurs, they rarely receive backing from a VC if their businesses are in low-growth market segments. What these investment flows reflect, then, is a consistent pattern of capital allocation into industries where most companies are likely to look good in the near term.

During this adolescent period of high and accelerating growth, it can be extremely hard to distinguish the eventual winners from the losers because their financial performance and growth rates look strikingly similar. Thus the critical challenge for the venture capitalist is to identify competent management that can execute—that is, supply the growing demand. In this period of accelerated growth, the financials of both the eventual winners and losers look strikingly similar.

Picking the wrong industry or betting on a technology risk in an unproven market segment is something VCs avoid. Genetic engineering companies illustrate this point. VC investments in high-growth segments are likely to have exit opportunities because investment bankers are continually looking for new high-growth issues to bring to market. The issues will be easier to sell and likely to support high relative valuations—and therefore high commissions for the investment bankers. Thus an effort of only several months on the part of a few professionals and brokers can result in millions of dollars in commissions.

As long as venture capitalists are able to exit the company and industry before it tops out, they can reap extraordinary returns at relatively low risk. Astute venture capitalists operate in a secure niche where traditional, low-cost financing is unavailable. High rewards can be paid to successful management teams, and institutional investment will be available to provide liquidity in a relatively short period of time. There are many variants of the basic deal structure, but whatever the specifics, the logic of the deal is always the same: to give investors in the venture capital fund both ample downside protection and a favorable position for additional investment if the company proves to be a winner.

The preferred provisions offer downside protection. For instance, the venture capitalists receive a liquidation preference. In addition, the deal often includes blocking rights or disproportional voting rights over key decisions, including the sale of the company or the timing of an IPO. The contract is also likely to contain downside protection in the form of antidilution clauses, or ratchets.

Such clauses protect against equity dilution if subsequent rounds of financing at lower values take place. Should the company stumble and have to raise more money at a lower valuation, the venture firm will be given enough shares to maintain its original equity position—that is, the total percentage of equity owned.

That preferential treatment typically comes at the expense of the common shareholders, or management, as well as investors who are not affiliated with the VC firm and who do not continue to invest on a pro rata basis.

Alternatively, if a company is doing well, investors enjoy upside provisions, sometimes giving them the right to put additional money into the venture at a predetermined price.

That means venture investors can increase their stakes in successful ventures at below market prices. How the Venture Capital Industry Works The venture capital industry has four main players: entrepreneurs who need funding; investors who want high returns; investment bankers who need companies to sell; and the venture capitalists who make money for themselves by making a market for the other three.

VC firms also protect themselves from risk by coinvesting with other firms. Rather, venture firms prefer to have two or three groups involved in most stages of financing.

Such relationships provide further portfolio diversification—that is, the ability to invest in more deals per dollar of invested capital. It is also a major subset of a much larger, complex part of the financial landscape known as the private markets. What is a venture capital firm? Venture capital firms are a type of investment firm that fund and mentor startups or other young, often tech-focused companies.

Similar to private equity PE firms , VC firms use capital raised from limited partners to invest in promising private companies. A firm's array of companies is called its portfolio, and the businesses themselves, portfolio companies. Examples of venture capital firms include: Sequoia Capital Headquartered in Menlo Park, CA, Sequoia Capital is a venture capital firm that invests in IT, mobile, internet, energy, media, retail sectors and more.

The firm is an active investor in ghost kitchens , an emerging space tracked by PitchBook , and it has invested in companies Uber , Bird , DoorDash and 23andMe. DN Capital London-based DN Capital in an early-stage VC firm that invests in software, fintech, mobile app, digital media, e-commerce companies and others.

Scott also regularly represents these clients in mergers and acquisitions, including a significant number of sales transactions with large, public companies. In addition, Scott devotes a significant portion of his practice to the representation of venture capital investors, negotiating and structuring portfolio company investments on behalf of these clients. Scott also represents established foreign companies seeking to expand their operations to the United States.

Scott speaks regularly on entrepreneurship, start-up companies and financings, delivering presentations to entrepreneurs, investors and lawyers at the Cambridge Innovation Center, Swissnex Boston, the American Bar Association and the MIT Enterprise Forum. Scott is a frequent writer on topics involving start-up companies and corporate law.

You can follow Scott on Twitter at bleierlaw. All rights reserved. Skip to content Venture Capitalists: Why and How They Invest in Startups From the size of the market to the solidity of the founding team, learn what VCs look for in startups and how they invest.

But what exactly is it? Venture capital VC is a form of equity financing where capital is invested in exchange for equity, typically a minority stake, in a company that looks poised for significant growth. A person who makes these investments is known as a venture capitalist. Technically, venture capital is a type of private equity PE. But usually the term 'private equity' is used to mean investments made into more mature businesses by PE firms.

We explain what private equity is and the differences between PE and VC in our blog post, What is private equity finance and how does it work? Unlike angel investors who use their own money to invest, venture capitalists most commonly work for venture capital firms which raise funds from outside investors.

These investors, known as limited partners, can include high net worth individuals, family offices, and institutional investors such as pension funds and insurance companies.

VCs use the capital they raise to invest in businesses with high growth potential or businesses that have already demonstrated impressive growth. Some VC firms have a diversified approach and invest in companies at various stages of the business lifecycle, while others focus specifically on certain stages.