Venture capital and private equity

Service Business

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Author: Michał Błauciak, Ideashirt.pl

Venture capital is a term for medium- and long-term investment capital, which is characterized by a high degree of risk, but may bring high profits in the future. It is a form of financing innovative (and therefore risky) investment projects. Many projects are created in the economy, which can be turned into very profitable ventures, but their implementation requires financial resources. Since the people who create such projects do not have enough capital, they have to reach for external capital. Banks are not eager to borrow money in such situations, because the implementation of projects is burdened with a high risk. The solution is special institutions that finance projects, and in return, in the event of a great success, they participate to a large extent in the profits from this venture, or, for example, become co-owners of the company (they have 40% or more of equity or preference shares in the company).

Venture Capital - beginnings

The beginnings of Venture Capital understood in its present form date back to the end of the 19th century. Initially - before World War II - venture capital activities (initially referred to as "development capital") were undertaken by rich entrepreneurs and wealthy families. For example, in 1938, Laurance Rockefeller (son of John Rockefeller - a famous entrepreneur and philanthropist) helped finance the creation of both Eastern Air Lines and Douglas. It was only after World War II that the institutional development of venture capital took place. The key player in this event was the American Research and Development Corporation. (ARDC). It is this institution that is credited with the first serious successes of venture capital, when in 1957, after an investment of $ 70,000 in Digital Equipment Corporation (DEC), it was valued at 355 million in 1968. Currently, due to the importance of creativity and innovation in the modern economy, the venture fund market capital is growing rapidly around the world. According to the Polish Association of Capital Investors (PSIK), in the years 2000-2004 private equity and venture capital funds invested over EUR 700 million in 300 companies in Poland (which constitutes 0.1% of Polish GDP).

Venture Capital and private equity

The difference between venture capital and private equity is the financing of companies of a different nature in terms of maturity. Venture capital is equity capital contributed for a limited period by external investors to small and medium-sized enterprises that have an innovative product, production method or service that has not yet been verified by the market, and therefore poses a high risk of investment failure. Private equity investments are investments in mature entities that are looking for sources of financing for further development and market consolidation. Having a long history by an entity trying to obtain financing, as opposed to venture capital investments, means that it is possible to trace the effectiveness of the company's management to date. Such a situation often results in a lowered investment risk, and thus a lower expected rate of return on investment that will be required by a potential investor. Venture capital and private equity solutions can also be a hybrid solution, in which some funds are supplied to share capital, and some are made available, for example, in the form of a loan, ordinary bonds or bonds converted into shares.

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As a result of the fund's entry into the company, not only is it recapitalized, but also investors provide management support of a very diverse nature. It may consist in direct performance of the activities of a member of the company's management board, legal, tax and organizational consultancy, etc. Investors also participate in the control of the implementation of projects co-financed by the fund. A potential investor, when considering private equity and venture capital investments, relies on information on the growth potential of a given entity in the coming years (in the case of private equity, also on its current position and market share). This potential is understood both as the potential of the target market for a given entity in terms of scope and territory, as well as the internal potential of a given entity. This means that an entity seeking private equity or venture capital financing should be active in a developing market that generates a constantly growing demand resulting from fundamental factors. From the internal side, these entities should, in turn, demonstrate a high level of quality in terms of products and business model. So they should have clearly defined competitive advantages in the medium and long term. These factors, however, are also often analyzed through the prism of future periods and the restructuring process that a potential investor is able to carry out in the company. Providers of capital are not focused on maximizing the company's current profits and their transfer in the form of profit sharing or dividends. The motive for the capital entry is the orientation on increasing the company's value in order to achieve the intended income, which takes the form of the resale of shares or stocks. At the time of resale, there is a capital exit, which is typical for this type of funds.