Some More Details on Venture Capital

Many mutual fund managers invest in specific areas depending on their areas of comfort.  They may be split by the capitalization/size, sector or the geographic region of the company.  The general partner or managing director of the venture capital fund raises capital and manages the investment portfolio.  Limited partners or shareholders are the investors.  Venture capitalists focus their investments based on the sector or geographic region of the company.  There is a third and most important category - the stage of financing that the target company is in.  The five stages are:

• Angel Investing - Funds are usually from friends and family.  Someone has an idea and a prototype and business plan has to be created.  Capital needs may range from $50,000 - $500,000.  Venture capitalists do not invest at this stage.
• Seed Capital - Smaller venture capital firms invest at this stage.  The prototype is being tested by clients for free to receive their feedback.  About $1 - $5 million are needed to finish and market the final prototype.
• Early Stage Venture Capital - The product is being made on a large scale and being testing by clients.  Unlike the Seed Capital stage, the product is not provided at no cost to the customer.  The financial goal is to break even.  About $2 million are needed at this stage.
• Late Stage Venture Capital - The new company is not losing money any more.  About $5 - $25 million are needed to expand production facilities and staff.
• Mezzanine Stage - The business is making money.  About $5 - $25 million are needed for the company to bridge the gap to the exit strategy - either going public or being sold to another company.  Money can also be used to buyout earlier investors and may be a loan or convertible offering through Rule 144A.

The venture capitalist has to complete different due diligence for each stage.  That is why they invest in particular ones.

Like hedge fund managers, the general partner charges management and incentive fees.  Management fees range from 1% - 3.5% of capital committed to the fund.  The incentive fee is also 20%.  Unlike hedge funds, venture capitalists are subject to a clawback provision.  This prevents them from charging fees if there are no profits at the end of the investment period, usually 7 - 10 years.  Incentive fees are not paid until all investments are paid back to the investors.