Venture Capital Financing

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.read more (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.read more.

Venture Capital Financing

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Methods of Venture Capital Financing

Following smart art shows the various investment methods of VC financing:

Methods of venture capital financing

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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:

Example

You can download this Venture Capital Financing Excel Template here – Venture Capital Financing Excel Template

Valuation of a company is done at two stages, at the time of VC financing. Following are the two stages:

  1. PRE – This is the valuation before VC Funding is received
  2. 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:

Venture Capital Financing Example 1
  • Cost of Capital – 22%

From this, we can calculate the probability that the project will last for 10 years:

Venture Capital Financing Example 1.1
  • (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

Example 1.2
  • =-$10000000 + $4106983
  • = -5,893,016.60

Therefore this project has a negative NPV and not worth investing.

Advantages

Disadvantages

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 –