What is Venture Capital: The Concept
Let’s understand this concept through a simple story. Let’s say A and B have developed an application which is getting a lot of customers and garnering media attention. The duo believes that their company has the potential of making it big in the market someday but banks are hesitant to lend them money because they think it is too risky.
Now, say Mr C comes in and sees what A and B have done and thinks that the benefits outweigh the risks. He gets to know the two, learns about their product, reads the business plan and finds out how much they have done so far.
Mr C likes what he sees, especially long-term potential, and decides to invest in A and B’s company. How much? That would depend on what stage the company is at — Pre-Seed, Seed, Series A, Series B and Series C. Now let’s say A and B have stayed in the game, gone through Series C and are ready for the next step. They decide to IPO, making their company public on the stock market. That goes well and Mr C sees a nice return on his initial investment. So there you have it!
This type of financing that the investor (Mr C) provides to start-up companies (A and B) and small businesses with innovative ideas that are believed to have long-term growth potential is called Venture Capital (VC). It is a high-risk, high-reward game that funds innovative ideas and keeps the tech world going.
Now you may ask what does the venture capitalist (Mr C) gets in return, initially?
He gets equity, an ownership stake in the start-up company in exchange for the investment. Some may consider this a downside for the start-up as the investor gets equity in their company, and, thus, a say in the company decisions. However, there are an equal number of advantages that VC funding brings along which we shall discuss in the latter part.
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By investing in the pool format, the investors are spreading out their risk into many different investments instead of taking the chance of putting all of their money in one start-up firm.
Who Provides Venture Capital? Where Does The Money Come From?
Venture Capital can be offered by:
● A high net worth individual (venture capitalist). They are also called Angel Investors.
● A Venture Capital firm.
● Investment bank or other financial institution.
It is important to note that Venture Capital and Venture Capital Funds are two different concepts. Let’s find out how?
Venture Capital Funds
A majority of VC investment is done in a pool format, where several investors (like Mr C) come together and combine their investment into one large fund. This fund is then invested in many different start-up companies and is called a Venture Capital Fund.
The firm which carries out this whole process of bringing together a pooled fund and investing it further is called a Venture Capital firm. In simple terms, a Venture Capital firm invests the financial capital of third party investors in start-ups that are too risky for the standard capital market of loans. The firm had dedicated experts who evaluate the profile of the start-up and invest the money in it.
By investing in the pool format, the investors are spreading out their risk into many different investments instead of taking the chance of putting all of their money in one start-up firm.
How Do VCs Make Money?
Success is not assured investing early in a start-up. In exchange for investing capital to help the start-up grow, the VC receives an ownership interest in the company. Because in the early days a company will not be worth very much, the fund’s ownership interest will be worth exactly what it paid. But as the company grows and becomes more valuable, the value of the fund’s corresponding percentage grows as well.
Ultimately, the company will be either sold to a larger company (at a higher price) or begins to sell shares through Initial public Offering (IPO). In either case, the VC fund sells the shares that it owns, for more money than it originally paid for them.
How Do VC Fund Managers/Firms Make Money?
Now, in a VC fund, there are General Partners (who manage/run the fund and maybe invest) and Limited Partners (who make the majority investment).
The general partners of a VC fund make money by raising the bulk of the capital that the fund’s investable capital from Limited Partners, usually institutions such as university endowments, insurance companies and pension funds. This is the money that is invested into the start-ups. When the fund itself makes money from a successful exit, the first thing that happens is that the original investments are returned to the Limited Partners, and then after that, 80% of profits are paid to the LPs, but 20% of the profits are retained by the
General Partners, who run the fund.
In addition, every year, the managers of the fund (the GPs), are entitled to pay themselves 2-3% of the total amount of the fund to pay their expenses and salaries.
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The return of the venture capitalist as a shareholder depends on the growth and profitability of the business. This return is generally earned when the venture capitalist exits.
In What Form Is VC Provided?
Venture Capital can be made in four methods:
● Equity Financing: As a start-up cannot guarantee timely returns to investors, equity financing proves beneficial. The investor’s contribution is not over 49% of the total stake, and so the with the entrepreneur.
● Conditional Loan: Conditional loans are the one that does not carry interest and are repayable to the lender in the form of royalty after the venture capital undertaking is able to make revenue. The royalty rate may vary from 2% to 15%, on the basis of factors such as gestation period, external risk and cash flow patterns.
● Income Note: A form of hybrid financing, that combines the characteristics of the traditional loan and conditional loan, on which the venture capital firm pays both royalty and interest, but at low rates.
● Participating Debentures: The interest on participating debentures is payable at three various rates, as per the phase of operation:
○ Start-up phase — Nil
○ Initial operations phase — Low rate of interest
○ After a particular level of operations – High rate of interest
● Convertible loans: The loans which are convertible into equity when interest on the loan is not paid within the stipulated period.
Stages of Venture Capital Financing
Let’s consider the stages your business will go through with VC financing.
Seed funding is at the earliest stage. Basically, something to get the party started.
Series A is for when the company has established product and market fit started to make some buzz and its customer base is growing fast.
Series B is when the company has started to make some considerable revenue in select markets and is looking to expand operations.
Series C and onwards is when the company has grown up and is likely operating on a global scale. It may be ready for an IPO, to be brought out by another company or continue operating as a private firm.
Is Obtaining VC Similar To Raising A Loan Or Debt?
While raising a loan or a debt, lenders have a legal right to interest on a loan and repayment of the capital irrespective of the success or failure of a business. Venture Capital is invested in exchange for an equity stake in the business. The return of the venture capitalist as a shareholder depends on the growth and profitability of the business. This return is generally earned when the venture capitalist exits by selling its shareholdings when the business is sold to another owner.
What Is The VC Process?
The first step involves submission of a business plan. The firm or the investor then performs due diligence, which includes thorough investigation of the start-up’s business model, products, management, and operating history, among other things.
If the investor finds the company’s offering promising, he will pledge an investment of capital in exchange for equity in the company. This money is not provided at once but in rounds (as discussed above).
The investor will then start taking an active role in the funded start-up, from giving advice to monitoring progress before providing the next round. A typical VC fund targets an average lifetime of 10 years.
What Happens To The VC’s Investment When A Start-Up Fails?
The answer to the second part of the question is – No. The founders are not personally on the hook for the company’s debts. When the company fails or ceases operations, any remaining assets are first divided out to pay off debt (some VC’s may have invested in convertible debt, so they will be a part of this payoff).
If there are any assets left after the company has paid its lenders, then the remainder is split among the equity owners. In short, if you sold share ownership in your firm to receive funds from investors, then you have to buy back that stock and repay the money.
For example, if you sold 100 shares in your company to raise $10,000 in funding to start a business, then you would need to buy those stocks back from the shareholders and pay shareholders $10,000 if the start-up goes bust.
It is important to note here that if a start-up goes bankrupt, the stock itself is usually worthless. You’d probably have to sell your liquid assets (intellectual property rights, factories, cash savings, etc) to repay the money you owe them. But if the company doesn’t have enough assets to pay back its investors in full, there is no additional personal responsibility/liability for the founders.
What You Need To Remember
The most important question you need to ask yourself as a start-up is, ‘Why does raising money from VCs make sense for your business?’ You need to have a very specific set of reasons to go in for VC funding than other options like founders’ money, angels, grants, bootstrapping, crowdfunding, strategic investors, friends & family.
It is designed to help ambitious start-ups scale but it’s not the only route to success. So make sure to educate yourself on all the possibilities available to your start-up before making a decision.
