Pros And Cons Of Venture Capital

1.1 What is Venture Capital?

Venture capital is a segment of private equity industry, which focuses on early-stage, high-potential, start-up companies. The venture capital fund earns money by owning equity in the companies it invests in, which usually have a new technology or business in high technology industries, such as biotechnology and IT, however with high risk. Funds are typically established as limited partnerships, which is a contract between institutional investors who become limited partners and the fund manager. The basic intermediation structure of venture capital and private equity funds is graphically summarized in Figure 1.

Figure.1 Venture Capital Financial Intermediation

Venture capital is a specific form of industrial finance(part

Economic growth is driven by innovation, led by young entrepreneurial firms, where financing of these firms can be difficult because of moral hazard and asymmetric information. Venture capitalists are the specialists at solving these problems, connecting entrepreneurs who have ideas and technology with investors who have money. Ensuring funding for innovative firms has positive externalities on the economy, so it makes sense for governments to promote an active venture capital market.

However, there is an argument for supporting the venture capital markets starting from standard macroeconomic theory: capital and labor should be available to produce output. How capital and labor are combined is central to how much output is produced. To increase the output with given inputs, productivity needs to increase through innovations. Innovations are often brought to the market and diffused through the economy by young entrepreneurial firms. New smaller firms often choose more risky product introduction strategies compared with more established firms. They fail more often, but they also successfully bring riskier high-impact innovations to the market more

Cash flow rights refer to who gets paid what fraction of the profits of the venture and at what time. Cash flow rights may be contingent in the division of profits depending on states of nature (bull versus bear economic conditions) and actions taken by different parties (both the entrepreneurs and the investors), which will affect the value of the venture. Examples of contingencies, upon which cash flow rights are allocated, include measures of financial performance (e.g., meeting sales or profit figures), measures of nonfinancial performance (e.g., obtaining a patent or FDA approval), issuance of equity (e.g., failure to achieve an IPO in five years provides the venture capital fund with the right to redeem preferred shares at a certain value), and taking certain actions (e.g., founding entrepreneur must stay with firm for a certain number of years or until a key employee is