Understanding Venture Capital – All You Need to Know
This article aims to give you a comprehensive idea of VC financing, the types of venture capital, and how to invest in venture capital.
The most crucial stage of a business is always the beginning. The success of any venture lies not only in its potential but also in the monetary funds it can raise to support the cause. You might have encountered exceptional business ideas that have yet to make it to reality because there needed to be more funds to take them forward. This is where Venture Capital comes to the rescue. It offers budding entrepreneurs financial support and assistance in areas like management and decision-making. This article aims to give you a comprehensive idea of VC financing, the types of venture capital, and how to invest in venture capital.
Venture Capital and Financing
Every company needs financial assistance beyond just the initial stages of establishment. Venture capital offers such assistance at every evolutionary stage of the business. The first-ever venture capital assistance was provided to a venture that aspired to incorporate x-ray technology to treat cancer patients. Studies say that in 2021, American VC-backed organizations will have raised at least $330 billion, a drastic leap from the $166 billion record set in 2020. To understand the impact of such funding initiatives on the lives of startup founders, you must understand what venture capital is.
What is Venture Capital?
When an investor or a group of investors believe in the potential of a startup company or business idea, they might want to invest in the business in return for equity or stakes in the company. Since it involves financial risks for the investors, it is also called risk capital. Venture capitalists only sometimes need to offer financial assistance in exchange for company shares; they can also provide their expertise, technical assistance, and management support to small businesses with little operating history or market knowledge. The capital can be from affluent investors, financial institutions, or banks.
How does Venture Capital work?
If you are a business owner looking for funds to grow your company, you must first submit a business plan to a VC firm or the investors in consideration. After going through the plan, due diligence will occur on behalf of the VC financing firm. This background check usually involves inspecting the company’s products, services, history, and management. If your company completes the diligence process, the firm shall offer you the capital in return for an equity stake. From this stage, the investing firms can be involved in the company’s management, technical, or decision-making process. The ultimate aim is to see the company grow.
Features of Venture Capital
Venture capital investments have certain prominent features in their operation:
- The tenure of investments is usually long-term in cases of VC financing.
- Venture capital firms invest in projects that exhibit innovation and growth potential.
- The funds are generally prone to high risk as the company’s growth may be uncertain in its initial stages.
- The investors need to be patient in expecting the returns but can secure capital gains in the future.
- The liquidity is very low in VC financing.
Pros and Cons of Venture Capital
While venture capital is favorable for new entrepreneurs with limited knowledge of stock markets and little cash flow, it can also take over control of some regions of the business. It is essential to weigh the pros and cons of venture capital before approaching an investing firm.
Pros of venture capital
- Unlike bank loan requirements, VC financing does not require companies to have the cash flow or a healthy financial background to offer funds.
- Besides financial services, VC firms provide technical and networking support to boost the company’s value.
- There is no obligation to pay the money back to the investors.
- There is no limit to the financing you can receive from an investment firm.
Cons of venture capital
- The investors can have a say in the company’s decisions; therefore, the founders cannot enjoy complete autonomy.
- The venture capitalists may expect larger company shares in return for the funds.
- It can impact the company’s operation when the VC financing firms exit earlier than expected.
- The process is time-consuming.
What is Venture Capital financing?
Venture capital financing takes place in stages called funding rounds. The financing rounds usually happen during the early seed funding stage in promising startups or the growth funding stage in exchange for a return. Depending on the ability of the company to perform in the future, VC financing firms may offer strategies, legal expertise, or marketing ideas. The process can be done in four methods: Equity Financing, Conditional loans, income notes, and Participating debenture.
Methods of Venture Capital financing
Venture capital financing helps budding entrepreneurs raise funds in exchange for a return. Based on the return they receive, there are four methods of VC financing.
- Equity Financing – When an investing firm receives an equity share for the funds they offer to a promising business venture, it is called equity financing.
- Conditional loan – This is similar to the loans you receive from a bank. Instead of repaying in cash, you offer them a royalty after the company generates profit in the future. There is no interest levied on the business owner.
- Income note – Income notes offer loans to businesses that can repay them through royalty and interest. It is important to note that interest received is minimal.
- Participating debenture – This type of VC financing allows the investors to exercise their right to involve in profits generated by the company.
Types and Stages of Venture Capital
There are three different types of venture capital: early stage, expansion, and buyout financing. The investment process occurs at six stages of venture capital funding, depending on the company’s evolution:
- Pre-seed – The pre-seed stage is when your business takes off its operations, and you work on creating impressive products or services that can exhibit your business’s worth. This stage is usually funded by a close circle of networks and acquaintances because it is too early for an investor to assess your potential. This is the right time to idealize your business plan, create strategies and draft any legal agreements that can make the investment process more manageable in the later stages. There are also a few micro Venture capitalists who can fund small businesses at the pre-seed stage.
- Seed – This is the stage when your business can prove its growth potential to Venture capital investors through demonstrations. The funds received at this stage can help set up a team, develop products, and perform market research. Funding businesses at the seed stage can be expensive as the risk is high. Fellow startup owners, wealthy investors from close circles, angel investors, and early venture capital can help raise money for these companies.
- Series A – The first official financing round happens at the Series A stage. You have built a moderate customer base, drafted a business plan, and shown regular cash flow. From this stage, you must improve your product, look for more investors and widen your workforce. This stage requires you to draft a long-term business plan demonstrating how your products can be converted into revenue. Traditional VC firms and angel investors usually fund companies at this stage with deliberate attempts to prevent losses in the future.
- Series B – The most crucial stage, Series B, is where your business demonstrates performance, unlike demonstrating potential in the Series A stage. It is the stage for more competition, expansion of business, and development operations. The firms or investors funding this stage will have expertise in startup investments. Both traditional and corporate Venture Capital firms mainly contribute to businesses at this stage.
- Series C and Beyond – By now, your business has reached a solid follower base, stable income flow, and potential to expand internationally. Investors experience lesser risk because they can already witness your business’s revenue. Many private equity firms, Hedge funds, financial institutions, and VC financing firms look for options to invest in companies at this stage. A business venture takes at least three years to reach this phase.
- Mezzanine – A stable business intends to expand further at the Mezzanine or bridge stage and needs finances to support huge events. Most of your early investors will now look for options to sell the equity shares and earn a return. Now that the early-stage investors are leaving, later-stage investors will come forward to support your business.
- Exit – This is the final stage of a business where the owners let the company go public to reward its investors with a profit for all the financing they have done since the initial stages. It can result in mergers with companies and attract new clientele. Going public is the best way to gather more capital, as there is more room for public stocks. However, going public is not mandatory, and you can still choose to receive funds from VC financing.
How to invest in Venture Capital?
Investing in venture capital is restricted to accredited investors as it requires a steady flow of money with commitment. However, retail investors can also support this by being updated on business development strategies and market insights through VC investors. Options like tokenization and incorporating innovative investment agreements allow all types of investors to fund potential business ideas in the future. Venture capital investors need resources that help them promptly perform due diligence. For VC financing experts to invest in a venture, thorough industry knowledge is non-negotiable.
Private Equity Vs. Venture Capital
Although venture capital is defined as a form of private equity, it is crucial to understand that they are not the same. The most apparent difference between the two is that the former provides funding to startups and companies that require finances from the early stages of the establishment. At the same time, the latter invests only in well-established ventures. Venture capital supports companies that still need to but are sure to generate revenue in the future. But private equity needs proof of consistent revenue to begin funding. What unites them both is the fact that both methods can expect a return only when the company they fund goes public or is sold.
Example of Venture Capital
One of the best examples of Venture Capital investments in startups is the initiative done through Sequoia Capital, which has funded many businesses such as Cisco Systems, Yahoo, and Apple Computer. Another famous VC firm is Andreessen Horowitz, founded in 2009. It has invested in multiple social media companies, including giants like Facebook, Twitter, Airbnb, and Okta. Uber, in 2010, received a capital of $1.5 million in its seed round. The investment of First Round Capital and Lowercase Capital, $510,000 and $300,000 during its early stage, had grown much in value to $2.1 billion and $1.1 billion by 2019.
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