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What is Venture Capital?

image for wutwhanfoto / Getty Images
wutwhanfoto / Getty Images

Among the various financing options entrepreneurs can turn to when starting a new company is venture capital. Venture capital is money that is given to help build new startup firms that often are considered to have both high-growth and high-risk potential. These companies generally center on health care or new technology, including things such as software, the Internet and networking. In addition,a new breed of venture capital firms has recently formed to focus solely on investing in socially responsible companies.

Entrepreneurs often turn to venture capitalists for money because their company is so new, unproven and risky that more traditional forms of financing, such as through banks, aren't readily available. Unlike other forms of financing where entrepreneurs are only required to pay back the loan amount plus interest, venture capital investments most commonly come in exchange for ownership shares in the company to ensure they have a say in its future direction.

Not all venture capital investments take place when a company is first being founded. Venture capitalists can provide funding throughout the various stages of a company's progression. Research from the National Venture Capital Association revealed that in 2010,venture capitalists invested approximately $22 billion into nearly 2,749 companies, including 1,000 of which received funding for the first time. Among the more famous companies to receive venture capital during their startup periods are Apple, Compaq, Microsoft and Google.

Venture capital funds come from venture capital firms, which comprise professional investors who understand the intricacies of financing and building newly formed companies. The money that venture capital firms invest comes from a variety of sources, including private and public pension funds, endowment funds, foundations, corporations and wealthy individuals, both domestic and foreign. Those who invest money in venture capital funds are considered limited partners, while the venture capitalists are the general partners charged with managing the fund and working with the individual companies.The general partners take a very active role in working with the company's founders and executives to ensure the company is growing in a profitable way.

In exchange for their funding, venture capitalists expect a high return on their investment as well as shares of the company. This means the relationship between the two parties can be lengthy. Instead of working to pay back the loan immediately, the venture capitalists work with the company five to 10 years before any money is repaid. At the end of the investment, venture capitalists will sell their shares of the company back to the owners, or through an initial public offering, for what they hope is significantly more than they initially put in. The most recent available statistics found more than 450 active U.S. venture capital firms that had each invested at least $5 million. The firms had an average fund size of nearly $150 million.

While they both provide capital to startup companies, there are several key differences between venture capitalists and angel investors. The biggest distinction is that venture capital comes from a firm or a business, while angel investments come from individuals. A second key difference is that while new startups typically receive millions of dollars in venture capital, angel investors typically never put more than $1 million into a project.

Another difference is that venture capitalists will generally invest in any startup they feel has the potential to make them money, while angel investors generally like to make investments in firms that work in industries they are personally familiar with. In addition, angel investors don't always require a hands-on role in the running of the company, as venture capitalists do.

Follow Chad Brooks on Twitter @cbrooks76 or BusinessNewsDaily @BNDarticles. We're also on Facebook.