Venture Capital Financing Meaning
Venture capital financing is a high-risk, high return investment methodology in which the money is invested in the form of equity in a company which is privately held i.e. not publicly traded on a stock exchange and is planned for three broad stages of the company – idea, expansion, and exit stage.
We need to understand two main aspects of this form of investing that, in most cases, the company is already selling a product at a smaller scale, and the venture capital sees the potential of the same and therefore thinks of scaling it up. Further, the exit from the company is pre-planned and generally takes the form of an initial public offeringInitial Public OfferingInitial Public Offering (IPO) is when the shares of the private companies are listed for the first time in the stock exchange for public trading and investment. This allows a private company to raise the capital for different purposes. (IPO) or a buyoutA BuyoutA buyout is a process of acquiring a controlling interest in a company, either via out-and-out purchase or through the purchase of controlling equity interest. The underlying principle is that the acquirer believes that the target company’s assets are undervalued..
Methods of Venture Capital Financing
Following smart art shows the various investment methods of VC financing:
These methods may vary in terminology or features from one geography to another; however, similar financing frameworks are available globally and cover mostly all formats of financing.
Stages of Venture Capital Financing
Following smart art shows the various stages of VC financing broadly based on Schilit’s classification; however, some of the terminologies are adapted based on the evolution of the same and terms of common usage in present time:
#1 – Seed Stage
At this stage, the funding is required for conducting market research for understanding the product feasibility or for the development of the product based on prior market research and prototype developed.
#2 – Early Stage
At this stage, commercial selling has not been initiated, and this is the reason why funding is required. This stage has two subparts:
- Start-up: The production has not started; funding is required for starting operations and doing initial marketing.
- First-Stage: Financing is done to begin commercial selling.
#3 – Formative Stage
This is a broader term that engulfs both of the prior two or either one of these stages because there is a very thin line demarcation between all such stages that determining exactly when one ended, and the other began is very difficult. Therefore in such products, instead of having several stages, one bigger round of funding is done to encompass all.
#4 – Later Stage
This is after commercial selling has begun and one of the most common stages where the most money is invested as the venture capitalists have higher faith in the product because they can visualize the same in a concrete manner. This involves the following sub-stages:
- Second Stage – The profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. has not yet occurred, that is, the commercial sales have begun, however, the company requires initial scaling up because it wants to make use of the economies of scaleEconomies Of ScaleEconomies of scale are the cost advantage a business achieves due to large-scale production and higher efficiency. and enter the profitability zone.
- Third Stage – Here, the financing is for long-term expansion, such as creating a new plant that caters to a new geographical region, and so on; therefore, this involves a huge marketing expense as well.
- Mezzanine Financing – This is similar to the straw before the last straw, i.e., the interim financing required by the company before its IPO is rolled out, and therefore, the name is given to it.
Valuation of a company is done at two stages, at the time of VC financing. Following are the two stages:
- PRE – This is the valuation before VC Funding is received
- POST – This is the valuation after VC Funding is received
- POST = PRE +Investment
Apart from this, there is a valuation of risk component that a venture capitalist considers before, which can be calculated in the following manner:
Suppose we are given the following information:
- Required investment: $10 million
- Expected valueExpected ValueExpected value refers to the anticipation of an investment's for a future period considering the various probabilities. It is evaluated as the product of probability distribution and outcomes. to be returned: $30 million
- Number of years: 10 years
- Probability of failure per year:
- Cost of Capital – 22%
From this, we can calculate the probability that the project will last for 10 years:
- (1-0.3) x (1-0.29) x (1-0.28) x (1-0.24)7
- = 5.24%
Calculation of the NPV of the Project
- =-$10000000 + $4106983
- = -5,893,016.60
Therefore this project has a negative NPV and not worth investing.
- High Return – If the venture is successful, there is a chance of a 40 to 50% return, which is higher than most investments. However, this return is not without the risks, so it is a trade-off, and only those who have this level of risk toleranceRisk ToleranceRisk tolerance is the investors' potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor's age, income, investment objective, responsibilities and financial condition. should invest in the same.
- Participation in Innovation – As the times when technology evolves, newer products keep entering the market, and older ones become obsolete, therefore, to keep the returns coming, it is best for a venture capitalist to keep investing in the innovations so that he develops a perennial return source.
- Launch-Pad for Entrepreneurship – Small business gets the necessary resources for expansion and getting higher sales. Therefore VC investment drives entrepreneurship.
- Lack of Liquidity – As the shares in the company are not traded on the stock exchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ., the investment becomes illiquid, and it is a big problem to find an interested buyer because the range of investor search becomes very limited. IPO or buyouts are more probable for successful ventures, however, if the venture is struggling or about to fail, exit becomes problematic.
- Long Term Investment – As the investment can take place at a very early stage, and the returns may come at a very later date, therefore gestation period till the time the company becomes attractive is quite longer than an average investment horizonInvestment HorizonThe term "investment horizon" refers to the amount of time an investor is expected to hold an investment portfolio or a security before selling it. Depending on the need for funds and risk appetite, the investor may invest for a few days or hours to a few years or decades.. Only patient investors can take such an investment, however, the returns compensate for a greater period of illiquidityIlliquidityIlliquid refers to an asset that cannot be converted to cash. Such assets suffer a valuation loss when sold in exchange for cash. Bonds, stocks and properties are some examples of illiquid investment..
- Market Value Determination is very Difficult –If the product is highly innovative, there might be very low chances of competitors existing and also there is a lower chance of gauging how the product will be received by the target audience. Investment is made before such clarity can be gained, therefore assessing the value of the company is difficult because, at times, very promising ideas fail. So determining the amount of investment becomes a little more difficult.
- Limited Information – As the companies have not existed for a long time, there is very little information regarding their financial position, further, as the product itself is new, the profitability numbers are also not present for too long a time, therefore finding a track record of the company and the product is very difficult.
- Lack of Information on Competition – These companies work in silos, and there is very little publicly available information of the company till it has reached probably the second or third stage of funding when the product is commercially selling, and marketing is done at a larger scale. So it is very difficult to know how many companies are working on similar ideas, and therefore determining a reasonable market share is also difficult. All these add to the cloudiness of investment.
This article has been a guide to Venture Capital Financing and its meaning. Here we discuss stages, methods of venture capital financing along with an example, advantages and disadvantages. You can learn more about from the following articles –