What is Venture Capital Funding ?
As per Wikipedia, Venture capital (VC) is a type of private equity. Its a form of financing that is provided by firms or funds to small, early-stage, emerging startups that are deemed to have high growth potential, or which have demonstrated high growth (in terms of number of employees, annual revenue, or both). Venture capital firms or funds invest in these early-stage companies in exchange for equity–an ownership stake–in the companies they invest in. Venture capitalists take on the risk of financing risky startups in the hopes that some of the firms they support will become successful in future and in this process VC firm will get multiple times return on their investment.
Venture funding is not meant to be long term funding. The central idea in such funding is to insert investment in an organization’s balance sheet and also infrastructure till a predetermined size and market credibility is reached so that is can be sold to a larger corporation and public-equity markets can get into the action and generate liquidity. Essentially, a venture Capitalist would purchase a stake in an entrepreneurial idea and nurture it for a short duration ending in an exit with the aid of an investment banker. Putting things simply, the big challenge here remains to progressively earn a superior return on investments in what are inherently risky business ventures.
How VC Funding Works?
It is a widely held belief that VC firms tend to invest in what they find to be great people and great ideas. But in practice it all comes down to VC firms investing in great industries which do well irrespective of existing competition and the current market.
VC firms and capitalists tend to focus on the central part of the traditional industry S-curve. They tend to stay away from the early stages, when the technologies haven’t been perfected and the market needs are still developing. They also stay away from later stages when competitive phases in the market arise and growth rates slow down without much that can be done to change things. Consider the disk drive industry. In 1983, more than 40 venture-funded companies and more than 80 others existed. By late 1984, the industry market value had plunged from $5.4 billion to $1.4 billion. Today only five major players remain.
The adolescent period of accelerating growth characterized by especially high growth, referring to the initial growth phase of the company, it becomes a major challenge to set apart the eventual gainers from the losers because initially both types of enterprise will have their growth curves and also financial performance look the same. At the initial stage such as this, companies are trying to deliver products as best as possible to a market which has displayed a need for the said product. At this stage the VC has the challenge to identifying management which can successfully execute tasks to meet market demand.
Even though selecting the wrong industry or betting on a technology risk in an unproven market segment is something VCs avoid, there are exceptions to this rule which tend to involve “concept” stocks. These are companies that hold great potential but take a really long time to succeed. A great example for this occurrence is, genetic engineering companies which act as a case study, proving this concept. In this particular case, the VC firm’s challenge is to recognize entrepreneurs who can advance key technologies to a certain stage such as approval from national and international health agencies that certify the process or product that has been invented.
Here comes the key part of the VC funding process. Once the VC firm has funded the portfolio company and time has elapsed, the VC’s will have to exit the company and the industry possibly before it reaches its peak, which will ensure the VC’s can harvest the highest profit or ROI at a relatively lower risk. Smart, and experienced VC’s work in a secure niche where conventional and low-cost financing is mostly unavailable. Provided things work out, high rewards can be paid to management teams which are successful and also institutional investment will be accessible to provide liquidity in a comparatively short time period.
Logic behind the VC Deal
There are many variations of the basic deal structure in VC fundraising styles, but irrespective of specifics, the logic of the deal doesn’t change: to provide investors in the venture capital fund both sufficient downside protection and aso favorable position for additional investment if the company proves to be a winner.
Venture Capital Industry Works like this – it has four main players: entrepreneurs needing funds; investors wanting high returns; investment bankers needing companies to sell; and finally the venture capitalists who generate money for themselves by making a market for the other three players
VC firms also need protection from investment risks which is gained in the form of an effort to co-invest with other VC firms. Usually the organizational structure in such as co-investing effort is a lead investor and follower investors. It is actually very rare to see a sole VC firm funding an individual company completely. It is considered common practice however for VC firms to have around three or two groups involved in all stages of financing. These act as media for diversification for VC firms leading the VC firms to invest in more deals for the same amount of cash. What they also do is reduce workloads of the VC partners by dividing risk assessment tasks amongst themselves during the due diligence period and also helps in managing the deal overall.
Another positive effect of having several VC firms collaborating on funding for a particular company, is that the credibility of the funding itself along with the company goes up. It has often been suggested by market observers that really top notch funds always will be a follower of top tier firms.
Expectation of higher returns in the VC deal
In return for financing one to two years of a company’s start-up, venture capitalists expect a ten times return of capital over five years. Combined with the preferred position, this is very high-cost capital: a loan with a 58% annual compound interest rate that cannot be prepaid. But that rate is necessary to deliver average fund returns above 20%. Funds are structured to guarantee partners a comfortable income while they work to generate those returns.
Great examples for such VC deals would be the ones done with Flipkart as well as Ola Cabs, where the ROI was tremendous for the VC firms involved. Since these firms were pioneers of sorts, and played the market right whist meeting the current demand without any shortage in supply, they have emerged as market leaders in the country with other VC firms queuing up to fund them and be a part of the huge bottom line.
Things to Consider Before Raising VC Funding:
Given below are the questions that every startup founder should ask before going for raising VC funding:
Whats the current size of the organization?
The first step is to analyse the future growth of your company and come up with realistic projections for the coming years. Based on the size of your company in the coming years you can decide whether to go in for VC funding or not.
Should I consider venture debt?
Venture debt means an assortment of debt financing products for companies that are looking for backing from VC firms. Usually venture debt is handed out by dedicated Venture debt funds (VC firms) or banks. This will act as a complement to equity financing. It represents a viable way to finance a business from far fewer sources than would otherwise be required.
It can present a way to finance business with lesser dilution then equity and also does not typically require a valuation to be set for the business. Also VC firm investments don’t require giving up board seats and have fewer governance requirements. But it also has to be kept in mind that like any other loan, venture debt should also be paid back with interest.