Introduction
In recent years, venture capital has grown in importance as a source of finance for startups and business owners. Venture capital firms offer this kind of investment to businesses with great development potential but maybe limited access to conventional forms of funding. In addition to financing, venture capitalists offer the businesses they invest in invaluable experience, networks, and assistance. Venture capital’s function in economic growth is not without debate, though. According to some, the pressure placed on venture capital fund managers to raise their upcoming funds may cause them to make dangerous bets and fuel boom and bust cycles. This article will investigate the contribution of venture capitalists to the “boom and bust” cycle shown on the NASDAQ Composite Index from 1994.
Main Body
It is not entirely correct to say that venture capitalists are solely to blame for the “boom and bust” cycle shown on the NASDAQ Composite Index since 1994. Although they certainly contributed to the cycle, venture capitalists were not the primary cause. The performance of technology businesses, especially startups, has a significant impact on the NASDAQ Composite Index. The rise of the technology industry and the funding of these businesses are both possible thanks to the vital contribution of venture capitalists. The NASDAQ Composite Index may rise due to increased startups brought on by the accessibility of venture capital investment.
For start-ups, venture capital (VC) is a crucial source of investment that enables rapid expansion and scaling (Owen and Mason, 2019). But this quick development frequently comes at the expense of consistency, and the stock marketplace is no exception. The NASDAQ Composite Index has undergone multiple “boom and bust” cycles in recent decades. Perhaps venture capitalists are to blame for this tendency is a matter of debate. By examining the venture capital business model, deal conditions, valuation methodology, fund structure, the connections between the venture fund managers and entrepreneurs, and the variables affecting the supply and demand for investment in venture capital funds, this essay will examine to what extent this statement is true.
Start-ups now rely heavily on venture capital (VC) as a source of investment since it gives them the resources they need to expand and scale up fast. With the aim of making significant returns on their investments, VC firms often invest in early-stage businesses with the potential to grow into huge and successful enterprises (Arroyo et al. 2019). An increasing corpus of work has been published recently that analyses how venture investors contribute to developing start-up businesses. This article will critically review this material to determine how much venture capitalists are to blame for the “boom and bust” cycle shown on the NASDAQ Composite Index since 1994.
Research by Kumar et al. (2022) claims that VC companies support the development of start-ups by offering mentorship, guidance, and networks in addition to cash. VC firms often invest in businesses with a strong potential for development and offer assistance in various areas, including company planning, advertising, financing, and operations. With this support, start-ups may successfully navigate the difficulties of growing up and succeed in their specific markets.
According to Harvard Business School research, VC companies are also vital in influencing the strategy and choices made by start-ups. According to the survey, VC firms are involved in the leadership ranks of the companies in their portfolio, offering advice and support to aid in the companies’ development and success. By giving start-ups access to tools and expertise they may not else have, venture capital firms also assist them in navigating the challenging business climate (Tolliyevna et al. 2023).
While VC companies can provide start-ups with a number of advantages, their business model also has the potential to contribute towards the “boom and bust” cycle shown in the NASDAQ Composite Market. VC firms frequently invest in early-stage businesses with significant growth potential, but this growth frequently comes at the expense of stability. Startups receiving venture capital investment are under stress to expand swiftly and turn a profit as soon as feasible. Aggressive expansion tactics may result from this pressure but might not be long-lasting.
As per the study by Baartmans, (2020), variables including macroeconomic circumstances, the accessibility of alternative investment possibilities, and the regulatory framework impact the availability of venture capital funds. These elements may play a role in the “boom and bust” cycle that the NASDAQ Composite Index exhibits. The availability of venture capital funds typically increases during great economic growth and a dearth of other investment alternatives, creating a “boom” in the market. However, the availability of venture capital funds declines when the economy is poor, or there are more favourable investment options, which causes a “bust” in the market.
In summary, venture capitalists play a critical role in developing start-ups by offering mentorship, guidance, and networks in addition to funding. However, the “boom and bust” cycle in the NASDAQ Composite Index may also be attributed to their business style. Even if they are not completely to blame for this issue, venture capitalists’ investment choices and techniques may impact the market’s general volatility. To reduce this instability, VC companies should promote sustainable growth methods and broaden their investment portfolios.
The venture capital business model, contract conditions, and the kinds of shares venture capitalists utilize in their investments must all be examined to analyze this subject. An analysis by Kato and Germinah, (2022) found that VC firms generate profits by making early-stage investments in businesses with substantial expansion potential and then transferring their ownership interests at a profit. In this way, venture capitalists are motivated to invest in businesses with the potential for quick growth and high profits.
The focus on quick expansion, though, might create issues. For instance, VC firms could encourage businesses to expand too rapidly, resulting in an unsustainable business strategy and an overvaluation.
As a result, the firm’s stock price can substantially rise before falling later, resulting in a cycle of booms and busts (Männasoo and Meriküll, 2020). Additionally, this occurrence could be influenced by the kinds of stocks and contract clauses that venture capitalists utilize in their investments. The preferred stock that ventures capital firms frequently buy when investing in businesses gives them advantages over common stockholders, such as having the capacity to impact corporate decisions, receiving dividends before common stockholders, and being given importance in the event of a liquidation. Preferred stock can benefit the shareholder and the company but can cause problems if the business does not perform as planned. This aspect could also be responsible for the boom and bust cycles seen in the stock market, claims an Investopedia article.
For instance, those with preferred shares could ask that the firm be liquidated if it struggles to produce income or profitability. This might result in a decline in the stock’s value and overall worth.
The “boom and bust” cycles in the stock market can be attributed to various factors, including the venture capital business model, deal conditions, and the types of investment shares. While VC firms are essential in supporting start-ups and fostering innovation, they must balance the desire for expansion and the long-term viability of the businesses they back.
Boom and bust cycles may be exacerbated by venture capital firms’ 10-year limited partnership structure and the “2 and 20” compensation model (Rhodes-Kropf, 2019). Venture capital funds’ limited partnership form enables investors to combine their assets, overseen by an investment adviser who invests in entrepreneurs. The management invests in promising businesses throughout the fund’s average 10-year lifecycle, nurtures them, and then exits by selling shares to strategic purchasers or via an initial public offering (IPO).
The “2 and 20” concept alludes to the normal venture capital fund fee schedule. In addition to receiving an incentive fee of 20% of the fund’s profits, fund managers are paid a 2% management charge on the funds they are responsible for (Morbee, 2020). Although this fee structure connects the fund manager’s interests with the desires of the investors, it may also inadvertently encourage managers to favour high-risk, high-reward assets over less risky ones.
Additionally, because venture capital funds are structured as 10-year limited partnerships, fund managers may feel pressured to deploy the cash they have obtained as soon as possible so that the fund may exit its assets before the fund expires. As a result, there may be a cycle of quick investments in companies with exaggerated valuations that, if the market fails to sustain them, may finally result in a crash.
A misunderstanding of objectives between the investor and the company founders can also result from the “2 and 20” approach. Fund management’s major objective is maximising profits for investors, which occasionally comes at the price of the startup’s longevity. Due to this imbalance, startup founders may be pressured to focus on growth and exit plans rather than developing long-term, sustainable enterprises.
By encouraging fund managers to prioritize high-risk, high-reward investments, the 10-year limited partnership structure of venture capital funds and the “2 and 20” fee model may contribute to boom and bust cycles by driving up valuations and emphasising immediate profits at the expense of a sustainable future.
Venture investors value businesses using various techniques, including the venture capital approach, similar company analysis, and discounted cash flow analysis. The widely-used venture capital approach calculates the company’s potential exit value before working backwards to calculate the needed return to make a profit for the venture capitalist. Venture investors value businesses using various techniques, including the venture capital approach, similar company analysis, and discounted cash flow analysis (Lozhkina et al. 2020). The widely-used venture capital approach calculates the company’s potential exit value before working backwards to calculate the needed return upon investment for the venture capitalist.
Furthermore, the need to use money as soon as possible might result in overpriced and a possible “boom and bust” cycle. A venture capital fund’s lifespan is generally 10 years, during which it must invest its cash and generate returns for its limited partners. Due to time constraints, investors may make hasty investment choices and invest money in overpriced enterprises, which might result in a bubble and subsequent “bust” cycle.
In conclusion, one critical element that raises the possibility of “boom and bust” cycles in the venture capital market is the method of valuation used within the entrepreneurial finance sector. The desire to deploy money rapidly, the high level of risk and uncertainty related to startups, and pricing based on optimistic expectations may all lead to overpriced and a possible “boom and bust” cycle.
The managers of venture capital funds and the entrepreneurial companies they support are close partners. The entrepreneurs carry out their company plans and make money for the investors, while the fund managers offer them monetary assistance and industry knowledge.
The investors and the entrepreneurial team often work together to decide when to depart a venture-backed firm (Lerner and Nanda, 2020). Since they are in charge of managing the funds of investors and maximizing returns, fund managers frequently play a key role in the decision-making process. But the exit time is also greatly influenced by the entrepreneurial team.
According to Rohn et al. (2021), developing a critical mass of clients or revenues, frequently fueled by the entrepreneurial team’s efforts, is the most frequent cause of a successful exit. On the other side, the incapacity of the entrepreneurial team to put their company strategy into action or the dearth of market demand for their goods or service is the most typical cause for an unsuccessful departure.
Cycles of boom and collapse in the venture capital business can also be attributed to the connection between investors and entrepreneurial teams. Fund managers may make risky and more volatile investments due to the pressure to provide large returns quickly, which may result in an elevated failure rate. Furthermore, the 10-year limited partnership form of venture capital funds may pressure fund managers to sell investments before the fund’s life cycle ends, resulting in a rush of sales that lowers returns.
Venture capital (VC) funds are crucial for giving startups the money they need to grow their operations. But because of the fierce competition in the VC sector, investors are under a lot of pressure to raise the following round of funding. The anticipation of large profits is a common source of this pressure, which can cause an industry-wide “boom and bust” cycle (Kim, 2021).
The need to seek money might cause venture capitalists to act unreasonably, claims an essay by Alpha JWC Ventures, an established Southeast Asian VC company. For instance, they could invest in businesses without performing sufficient due diligence or estimates, which would cause start-ups to be overvalued. A bubble might develop due to too much capital pursuing too few profitable opportunities. The bubble eventually collapses, leaving investors with a sizable loss.
Venture capitalists may decide to invest in industries or businesses that are not a suitable match for their funds due to the pressure to obtain money. This may cause some promising startups to obtain insufficient capital while other businesses receive more funding than they require or can effectively use.
The availability and popularity of venture capital investment money also influence the boom and bust cycle. A study by Ahmed et al. (2020) found that a number of variables, such as the rate of interest, the health of the economy, and the accessibility of cash for institutional investors, impacted the availability of venture capital.
The number of start-ups looking for capital, the calibre of the transactions, and the success of the current VC funds all impact the need for VC funds.
VC capital is more in demand during economic booms because start-ups are more risk-averse and hopeful about their future. However, when investors grow more risk-averse during a recession, the need for VC funds might decline. As a result, there may not be enough VC funding available to match the demand from start-ups, which might lead to a “bust” cycle.
Conclusion
It is impossible to exaggerate the impact of venture investors on the startup environment. They offer the capital and industry knowledge that early-stage businesses need to develop and prosper. However, a “boom and bust” cycle may result from the pressure placed on venture capital fund organisers to raise their upcoming funds and the variables affecting the demand and supply for venture capital investment funds.
It is not correct to simply attribute the “boom and bust” cycle seen on the NASDAQ Composite Index since 1994 to venture capitalists, although they do have a role in the stock market. Changes in sentiment among investors, the state of the economy, and regulatory regulations are just a few of the many elements that influence this occurrence.
Additionally, the entrepreneurial teams that get backing from venture capitalists significantly impact a firm’s success or failure. Venture capitalists might contribute to the “boom and bust” cycles seen in the NASDAQ Composite Index, but they are not primarily to blame for these changes. It is crucial to have a thorough awareness of the larger economic and regulatory context to analyze the influence of venture capitalists on the ecosystem of startups and the stock market.
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