What is Venture Capital
Venture capital (abbreviated as VC) is an attractive funding option for young companies with high growth potential, most often in high technology industries. These new companies are unable to raise funds in more conventional ways like bank loans. Investors assume high risk of loss in exchange for high potential of future growth, significant control over company decisions, and a portion of the company's ownership.
How to Obtain Venture Capital
Obtaining venture capital is different from raising debt or a loan from a lender. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the success or failure of a business. In contrast, the venture capitalist's return is dependent on the growth and profitability of the business. Return is earned when the venture capitalist sells its shareholdings. This happens when the business goes public, issues shares to the general public through an Initial Public Offering (IPO), or is acquired by a third party company.
It is also in the venture capitalist's interest to nurture the companies in which they invest. This increases the likelihood of reaching an IPO stage when valuations give high returns. Therefore, in addition to the initial financial funding, VC firms provide time, expertise and valuable business connections. As these investments are illiquid and require 3-7 years to reap full benefit, venture capitalists carry out due diligence, conducting very detailed investigations into the firms prior to investment. This process includes examining the firm's financial records and all aspects of its operations. Most venture capitalists will also require significant detail about a company's business plan. Venture investors may obtain special privileges that are not granted to holders of common stock, including:
- Anti-dilution protection
- Guaranteed seats on the company's board.
- Positive and negative covenants that the company must abide by
- Registration right, defined as the special rights to demand registration of their stock on public exchanges, and to participate in an IPO
- Representations and warranties.These are statements in which the company gives certain assurances to the VC firm as to the operations and financial condition of the company
- Liquidation preferences - in any liquidation event, the VC investors get their money back, often with interest before common stock is paid any funds from liquidation.
Initially, VC firms establish a fund which pools money raised from individuals, companies and other interested parties. This pooled investment vehicle is then used for investment in start-up enterprises.
Structure of a Venture Capital Firm
The venture capital firm pools capital from investors and allocates it to venture efforts deemed worthy of investment.
Stages of Funding
Through informal and formal business networks, VC firms and entrepreneurs will meet to discuss the business plan and investment possibilities.There are different rounds of financing corresponding to different stages of a company's development:
- Seed money round: The entrepreneur must convince the venture capitalist to fund their business vision. The VC firm is looking for a number of qualities including a solid business plan, an effective management team, high growth potential, and high target minimum returns. The VC firm will investigate into the technical and economic feasibility of the venture's idea. If it is not directly feasible, but the investor sees potential, the investor will choose to invest some seed money for further investigation.
- Start-up: VC firms provide capital to early stage firms that need funding for marketing and product development. Organization of the company is formed, with finalization of the management team and establishment of an individual from the VC firm on the company's board. The prototype product/idea is developed and tested. Market research for the idea is conducted, and the VC firm also monitors product feasibility and capability of the management. If at this stage the VC firm is not satisfied with the progress from market research, the VC firm may stop their funding and the venture will have to search for other sources of funding.
- Second-Round: Early-stage companies that are selling product but not yet turning a profit receive working capital.
- Expansion/Mezzanine financing: As the name suggests, VC firms provide expansion money for a newly profitable company.
- Bridge financing/exit of venture capitalist : Finally, the company is expected to either "go public" or be bought by a third-party company. The VC firm then exits by selling off its shareholdings of the company. The investor's risk of losing the investment decreases as the company advances from one round to the next of this process.