Venture Capital Funds

Venture Capital Funds pool investor money for high-risk, high-reward investments in startups with big growth potential. Read to know more.
What are Venture Capital Funds
3 mins read
29 March 2024

The principle of pooled investments is an effective technique that can deliver significant returns for the investors involved. It entails pooling together funds from different investors to purchase a basket of assets and then distributing any potential profits among the investors proportionate to their capital. Mutual funds work on this principle. So do Venture Capital Funds (VCFs).

In this article, you will find out what venture capital funds are, how they work and what their advantages and limitations include.

What is a venture capital fund

A venture capital fund is a type of private equity investment where the capital pooled from different investors is used to finance startups and other enterprises that have promising growth potential. These enterprises may deliver extremely high returns if their journey of growth pans out as expected.

However, on the flip side, the investments made by a venture capital fund also carry a high degree of risk. Due to the high-risk and high-reward proposition they offer, VCFs are not suitable for all investors. Only those with a high tolerance for risk and vast amounts of capital at their disposal — like High Net-Worth Individuals (HNIs), institutional investors and other fund houses — can afford to handle such a risk-reward equation.

Understanding how venture capital funds work

Now that you know the meaning of a venture capital fund, let us examine how they work. The basic working premise of a venture capital fund is similar to a mutual fund’s. Both types of investments use pooled funds to make investments in select assets. However, unlike mutual funds that are managed by fund houses or Asset Management Companies (AMCs), venture capital funds are managed by venture capital firms.

To minimise the high level of risk associated with investing in high-growth enterprises, venture capital funds adopt a highly diversified investment strategy. They invest in a wide range of companies at different stages of their growth journey. Due to the inherent diversification, the risk is well-distributed.

Additionally, since venture capital funds invest small sums in different companies, the risk from various failed investments may be offset by a few successful companies that deliver high returns. Nevertheless, the risk remains high even when compared with other equity investment options. To further minimise this risk, many venture capital firms also participate in the investments made by the venture capital funds they manage.

Let us examine how venture capital firms operate.

Decoding venture capital firms

Venture capital firms identify startups or companies that have extremely high growth potential. Then, in the context of venture capital funds, venture capital firms act as both the manager and the investor. This means that the firm also invests in the companies that make up the fund’s portfolio.

Since the risk involved is fairly high, the venture capital firm seeks a share of control in the company, so it can influence the decisions and growth trajectory of the business. This way, the risk is reduced slightly because the firm can have a say in how the business it has invested in functions.

3 types of venture capital funds based on the stage of funding

Contrary to popular belief, venture capital funds do not invest only in newly launched startups. Since their primary goal is to identify and tap into growth opportunities, these funds may choose to invest in any stage of a business’s operations — as long as the potential for exponential returns exists.

Based on the stage of funding offered to businesses, a venture capital fund may be any one of the following types.

1. VCFs that offer early-stage funding

These venture capital funds invest in startups that are just launched or even in the pre-launch stage. They help businesses establish their presence in the market and kickstart their operations. Such early-stage funding can be any one of the following three kinds:

  • Startup funding: This is money offered to startups to support product or service development.
  • Seed financing: This is the earliest stage of funding offered for startups, often in return for equity.
  • First-stage financing: This round of funding is necessary to push early-stage growth in a new company.

2. VCFs that offer expansion funding

Venture capital funds that offer this kind of financing aim to leverage the growth potential of companies that are undergoing significant expansions. Such expansion-stage funding can also be of different types, as outlined below:

  • Mezzanine financing: Mezzanine financing is a mix of both debt and equity, where the venture capital fund) has a right to convert the debt to equity if there is a default.
  • Second-stage funding: This type of funding is offered to companies that have grown beyond the startup phase and need capital to support further expansion.
  • Bridge funding: True to its name, bridge financing is offered to help growing businesses meet their short-term capital requirements.

3. VCFs that offer acquisition funding

Acquisition financing offered by venture capital funds helps companies boost their growth by acquiring other businesses. Some examples of this type of funding include the following:

  • Acquisition funding: This kind of capital helps a company acquire another business. It may involve a mix of debt and equity.
  • Buyout funding: This involves funding the purchase of a company by its management or investors.

Pros and cons of VCFs

Venture capital funds come with some distinct advantages and limitations, as outlined below.

Pros of VCFs:

  • No repayment involved
  • Facilitates business expansion
  • Access to business expertise
  • Potential for high rewards for investors

Cons of VCFs:

  • Dilution of ownership
  • May be challenging and time-consuming to secure funding

Conclusion

For investors, venture capital funds offer a suitable avenue to leverage the high growth potential of eligible companies. However, retail investors typically avoid these investments due to the high level of risk involved and the amount of capital deployed.

That said, this is changing as an increasing number of individuals are eager to tap into the growth opportunities offered by early-stage investing and venture capital funds. If you are not ready to take on such significant risks, you can look at the 1,000+ mutual funds listed on the Bajaj Finserv Mutual Fund Platform and make an informed choice.