What is Venture Capital?
Venture capital (VC) refers to a type of long-term finance extended to startups with high-growth potential to help them succeed exponentially. The investors are called venture capitalists who bear the excessive financial risk and provide guidance to startups to attain their objectives. In exchange, the investors get ownership in the business and multiple returns for when the company makes it big.
The National Bureau of Economic Research has stated that the average returns for venture capital firms is around 25 per cent of their investments. However, it is vital to understand that not all businesses become profitable or highly scalable. Nevertheless, the analytical and economical expertise of a venture capitalist comes in handy for start-ups during various stages of growth.
Table of contents
- Venture capital is a kind of financing available to high-growth potential startups and small businesses in their early stage to make it big in the business world.
- VC funding comes from a venture capitalist who could be a high-net-worth individual or firm that provides funding to young enterprises capable of growth.
- It is a high-risk, high return investment opportunity for the venture capitalists.
- The various stages in which VC funding can take place includes early-stage financing, expansion financing and acquisition or buyout financing.
- Venture capital and private equity funding differ due to the time of investment. VCs invest when the startup is still trying to build itself while PE firms arrive at a more established stage when the startup has somewhat gained a place in the market.
Venture Capital Explained
Venture capital is crucial for startups and small companies to get funds as they don’t have access to capital markets. Resultantly, such funding has become popular as it provides above-average returns to investors when successful. Many venture capitalists are wealthy investors with finance and expertise. Other sources of VC funding are financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. , banks, pension funds, and corporations.
Usually, venture capital funds take this risk with an aim to acquire preferred equity or general equity. When the startup undergoes mergersMergersMerger refers to a strategic process whereby two or more companies mutually form a new single legal venture. For example, in 2015, ketchup maker H.J. Heinz Co and Kraft Foods Group Inc merged their business to become Kraft Heinz Company, a leading global food and beverage firm., acquisitionsAcquisitionsAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion., or 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. listing, these shares can be converted to cash with the appreciated share value, giving hefty returns.
A general partnerGeneral PartnerA general partner (GP) refers to the private equity firm responsible for managing a private equity fund. The private equity firm acts as a GP, and the external investors are limited partners (LPs). (GP) manages the VC fund and works on behalf of the VC firm as a partner. GP raises and manages venture funds. Within the startup, the GP makes required investment decisions to help them achieve their goals. In addition, there are limited partnersLimited PartnersIn a limited partnership, two or more individuals form an entity to undertake business activities and share profits. At least one person acts as a general partner against one limited partner who will have limited liability enjoying the benefits of less stringent tax laws. (LPs) who commit capital to the venture fund. LPs are mostly institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.. Venture capital firms invest in a startup at a certain stage of the business cycle, such as seeding or early growth. The funds are committed for 5-8 years.
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Video Explanation of Venture Capital
Venture capital firms have a systematic and a calculated approach towards funding a start-up. Different firms might have different approaches and methods depending on their working styles. However, a common approach to funding is as discussed below.
Stage I: Submission of business plan
Firstly, the entrepreneur presents a plan to the venture capitalist to convey the business idea. It could include details on target markets, expected profit range, business goals, and a roadmap to goals. The requisite details are an executive summary of the proposal, forecast financials, competitive scenario. etc. If the VC is attracted to the plan, then the process progresses to the second stage.
Stage II: First meeting among parties
After going through the business plan, the VC calls for a face-to-face meeting with the startup’s management. This meeting is essential because it determines whether the startup will get the business. If all goes well, the parties move ahead.
Stage III: Conducting Due Diligence
This process is a quick evaluation of the references given by business owners about the customer, business strategy evaluation, re-confirmation of debtorsDebtorsA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. and creditorsCreditorsA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties. , and a quick check on other relevant information exchanged between the two parties.
Stage IV: Finalizing the Term Sheet
After conducting the due diligence, if everything falls in place, the venture capitalist would offer a term sheet. A term sheetTerm SheetA term sheet is an agreement facilitating a fundraising process whereby two parties mutually agree to abide by the mentioned clauses concerning the investment. is a nonbinding document that lists the terms & conditions between two parties. It is negotiable and is finalized after all parties agree to it. Post agreement, all legal documents are prepared. After this, the funds are released to the business.
The type of VC funding is based on the money extended at a particular stage of the startup’s development. Venture capital funds and private equity differ here because they invest in a company at different stages and methods. VCs invest at the early stages of the startup with the PE firms showing up at a more established stage.
The venture capital funding procedure is completed through the six stages, which are as follows –
- Seed Money: This is low-level financing provided for developing an idea of an entrepreneur.
- Startup: These are businesses that are operational and need finance for meeting marketing or product development expenses. They receive funding to finish the development of their products or services.
- First Round: This type of finance is for manufacturing and funding early sales. It helps companies who have utilized all their capital and need fresh finance to start full-fledged business activities.
- Second Round: This financing is for companies involved in sales but are still not in profits or are at break-even.
- Third Round: These funds are used for backing the expansion of a new valuable company.
- Fourth Round: Also termed as bridge financing, this is the money used for going public.
Early-stage financing has seed financing, startup financing & first stage financing as three subdivisions. In contrast, expansion financing can be categorized into second-stage financing, bridge financingBridge FinancingBridge financing is a type of financing that helps with the procurement of short-term loans to meet immediate business needs until long-term financing can be obtained. Such financing is frequently used in times of cash crunch and limited resources, and it usually carries a higher interest rate., and third stage financing or mezzanine financingMezzanine FinancingMezzanine financing is a type of financing that combines the characteristics of debt and equity financing by granting lenders the right to convert their loan into equity in the event of a default (only after other senior debts are paid off)..
Apart from this, second-stage financing is also provided to companies for expanding their business. Bridge financing is generally offered as short-term interest-only finance. It is also provided to assist companies that employ initial public offersInitial Public OffersAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange. (IPO). VC firms also keep highly liquid investments such as money market assets and cash reserves referred to an as dry powderDry PowderDry Powder is cash reserves set aside for contingencies or investment opportunities so that they can be used at the right time. It is also known as reserves set aside for tough times or downfall with the intention of safeguarding the investments made by the investors, thus increasing the investors' faith and providing long-term benefit to the business organization.. They are kept as a reserve to meet future obligations.
Let us understand the how venture capital firms invest their money and back start-ups in detail with the help of a couple of examples.
XYZ venture capitalists Ltd., got an investment pitch from a food and beverages company. The business was based on the franchisee model through which the company has already owned 5 company-owned outlets, and 15 franchisee outlets.
They were looking to raise funds to meet their production expansion and marketing requirements and through the bootstrapping in the 10 years of their existence, they had become profitable from the third year itself.
It was also a great sign that the company’s first two years in losses were due to excessive investments towards research and development (R&D). Therefore, XYZ decided to invest $15.3 million into the company in the first round of funding for a 5% stake.
Uber has repeatedly raised finance from various venture capitalists in multiple funding rounds. You can take a look at an excerpt from Uber’s financing rounds featuring seed-Series C in the picture above. It received the seed financing of 1.6 million in 2010. After series of monetary influx, Uber finally went public in 2019, closing on the first day with a market cap of $69.7 billion.
Google in 1999, acquired $25 million from Kleiner Perkins Caufield & Byers and Sequoia Capital. These venture capitalists reaped enormous returns as Google today has become an indispensable part of the internet.
WhatsApp – Sequoia invested about $8 million in WhatsApp in 2011 and $60 million over the years. It made around $3 billion from WhatsApp. But the VC firm hit the jackpot when WhatsApp got acquired by Facebook for $16 billion, helping Sequoia make many billion bucks.
Sequoia Capital is one of the oldest and largest venture capital firms in the world. It has made billions from funding many startups such as Apple, Google, Zoom, Instagram, Snowflake, etc. As per Forbes, Alfred Lin and Neil Shen of Sequoia group are the top venture capitalists worldwide in 2021. Some of the top names from the list are below.
Exit routes refer to an event that would wrap a deal for venture capital funds. At the end of a successful VC deal, the exit route would lead venture capitalists to close their investment and reap profits from it. Usually, an exit route for a venture capital firm is the startup getting any of the following-
- Initial Public Offering (IPO)
- Promoters buying back the equity
- Mergers & Acquisitions
- Selling the stake to other strategic investors
Like private equity associatesPrivate Equity AssociatesA Private Equity Associate assists other senior associates and partners in identifying a well-suited target to invest in and reaping the benefits by selling it at a profit, as well as overseeing due diligence, handling communication, and preparing financial models., there are many jobs for efficient venture capital analysts offering competitive salaries. As per Glassdoor, the average annual salary of a venture capital associate in the US is $83,006. This is because analysts and fund managers play a crucial role in cracking successful VC deals. Suppose their investments hit the right chord, VCs pocket heavy returns. Normally, a VC firm charges around a 2-2.5 % fee from the startup to cover expenses.
Most often, investors also acquire many shares of the startup. When a major event like an IPO occurs, coupled with massive share price appreciation, venture capital firms make heavy profits. Look at the earnings of Google and WhatsApp investors! The annual internal rate of returnInternal Rate Of ReturnInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected. (IRR) ranges between 20-60, much higher than traditional investments. However, not all startups hit it off. As such many VC deals fail terribly, landing investors in severe losses.
Venture capital (VC) is a mode of financing a startup where investors help growth-exhibiting budding companies with long term equity finance. They also provide practical guidance in exchange for a share in their risks as well as rewards. In addition, it ensures a solid capital base for future growth. For example, Xiaomi had received a substantial investment from VC firm 5Y Capital.
Venture capital can be categorized into the following three types:
• Early-stage financing – seed financing, startup financing and first-stage financing; • Expansion financing – second-stage financing, bridge financing and third stage financing or mezzanine financing;
• Acquisition or buyout financing.
A venture capitalist earns an enormous return on investment in the following three ways:
1. Carry or carried interest: The fund manager many times receives a percentage share in the company’s profit.
2. Management fees: It is charged by the VC firm from the startup for providing their professional management services and to cover off expenses. It is usually 2-2.5%.
3. Gains – Refers to profits made as a shareholder from acquisition/merger or IPO listing of the startup.
This article has been a guide to what is Venture Capital. Here we explain venture capital using examples of firms, funding stages, methods, exit, and returns. You may learn more about Private Equity and Venture Capital from the following articles –
- Examples of Joint Venture
- Types of Bank CapitalTypes Of Bank CapitalBank Capital, also known as the net worth of the bank is the difference between a bank’s assets and its liabilities and primarily acts as a reserve against unexpected losses.
- Vendor Financing ExampleVendor Financing ExampleVendor Financing, also known as trade credit, is lending of money by the vendor to its customers who in turn use the money to buy products/services from the same vendor. Vendor Financing is when the borrower uses the borrowed amount for goods/services from the lender itself. The vendor gives a line of credit to its customer based on their goodwill and rapport.
- Compare – Angel Investment vs. Venture CapitalCompare - Angel Investment Vs. Venture CapitalAngel investments are made by high-net-worth individuals, who often are informal investors, whereas venture capital investments are made by venture capital firms, which are funded by companies that pool funds from numerous institutional investors or individuals.