What is venture capital financing?
This type of private equity can be provided at various stages or funding rounds. Venture capital financing is a risky equity investing through professionally managed funds. The firms provide seed, early-stage and later-stage funding to high growth businesses including startups.
Venture capital firms provide an important link between finance and innovation. The investment is intended to boost a product's success or growth in the marketplace. The investors expect multiple returns on their initial investment.
Investors in venture capital firms include institutional investors and high net worth individuals. The investment fund is pooled together by dedicated investment firms.
Capital is invested in exchange for an equity stake in the business rather than as a loan. This is a suitable funding option for companies and businesses with large up-front capital requirements.
How venture capital financing works
Venture capital plays only a minor role in funding basic innovation. Venture capital provide funding for a company when it begins to commercialize its innovation.
The funds may be used for building the infrastructure required to grow the business. This type of financing is not long-term.
The idea is to invest in a business balance sheet and infrastructure until it reaches a sufficient size and credibility so that it can be sold.
The business can be sold to a major corporation or through institutional public-equity markets to provide liquidity during exit.
A venture capitalist will buy a stake in a business, nurtures it for a short period, and then exits with the help of an investment banker.
Investors in venture capital funds are large institutions such as pension funds, financial firms, insurance companies, and endowments funds.
The investors often expect a return of between 25% and 35% per year over the lifetime of the investment.
To meet investor expectations, venture firms invest in good industries that are more competitive and growing fast.
More than 80% of the money invested by venture capitalists goes into the accelerated growth phase of a company’s life cycle.
Most experienced venture capitalists operate in a secure niche where traditional, low-cost financing is unavailable.
High rewards can be paid to successful management teams. Institutional investment is made available to provide liquidity in a relatively short period of time.
Venture capitalist firms prefer to have two or three groups involved in most stages of financing.
Such relationships provide further portfolio diversification. Venture capitalists expect a ten times return of capital over five years.
Funds are often structured to guarantee partners a comfortable income while they work to generate returns.
The investors get 70% to 80% of the capital gains, and the venture capitalists get the remaining 20% to 30%.
The amount of money any partner receives apart from salary depends on the total growth of the portfolio’s value, and the amount of money managed per partner.
Given the portfolio approach and the deal structures, only 10% to 20% of companies funded by venture capital need to be real winners.
This helps to achieve the targeted return rate of 25% to 30%. Venture capitalists identify and attract new deals.
They also monitor existing deals, allocate additional capital to the most successful deals, and assist with exit options.
Experienced firms are able to allocate their time well among the various functions and deals involved.
The financial incentive for partners in a VC firm is to manage as much money as possible.
The more money they manage, the less time they have to nurture and advise business owners.
The fund makes investments over the course of the first two or three years. Any venture capital investment is active for up to five years.
The fund harvests the returns over the last two to three years. By understanding how venture capital financing works, entrepreneurs can mitigate their risks and increase their potential rewards.
Many business owners think that venture capitalists are looking for good ideas when, in fact, they are looking for good managers in particular industry segments.
Venture capital is an attractive deal for business owners. The reputations of venture capital firms are often built on one or two good investments.
Venture capital funding process
The venture capital funding process involves several phases in a company’s development:
Phase 1: Idea generation and submission of the Business Plan
The first phase when approaching a venture capital firm is to submit a business plan which should include:
- An executive summary of the business proposal
- Description of the business opportunity, market potential, and size
- Review on the existing and expected competition
- Financial projections statements
- Management of the company
Once the preliminary study is done, a one-to-one meeting is called for discussing the project in detail.
Phase 3: Due diligence
This phase involves solving of questions related to customers, product and business strategy evaluations, management interviews, and other such exchanges of information.
Phase 4: Term sheets and funding
This whereby the VC offers a non-binding document (term sheet) explaining the basic terms and conditions of the investment agreement.
After agreements and on completion of legal documents and legal due diligence, funds are made available.
Phase 5: Exit
The investor leaves the company after some time (usually 4 to 6 years) after the first investment by initiating a merger, acquisition, or initial public offering (IPO).
It's important to prepare well for your first meeting with a venture capitalist so you can make a positive first impression, and secure a follow-up meeting.
Venture Capital Financing Stages
- Seed Stage
- Startup Stage
- First Stage
- Expansion Stage
- Bridge Stage
Types of venture capital financing
The three main types of venture capital are early stage financing, expansion financing and acquisition/buyout financing.
Early Stage Financing
Early stage financing includes seed financing, startup financing and first stage financing.
Expansion financing includes second-stage (expansion) financing, bridge financing and third stage financing or mezzanine financing.
Acquisition or Buyout Financing
Acquisition or buyout financing includes acquisition finance and management or leveraged buyout financing.
How to apply for venture capital funding
To maximize the likelihood of success, it is highly advisable for entrepreneurs to undertake advance research to learn about the venture capital process.
Venture capitalists are very selective. They look for startups with significant growth potential that caters to a large market.
The market opportunity for your product or service offering has to be attractive enough to make investors want to allocate funds to your business venture.
It is important to satisfy an investor’s return expectations when seeking venture capital.
A good unique product or service can draw an investor’s attention quickly. It also makes it difficult for competitors to replicate what you offer.
When you pitch your idea to investors, back it up with data. Have quality data, research and metrics for every claim.
This is the only way to appear authoritative and convince investors that you know what you are doing.
How to attract venture capital investors
Venture capitalists are experienced and sophisticated. You should undergo substantial internal planning in anticipation of becoming a portfolio company.
Here are some steps to take:
- Form a legal business Entity
- Enlist legal help
- Build a good management team
- Be committed to your business and product
- Be prepared to back up your numbers and don't rely on other companies as a blueprint for your own success
- Get some results and show significant customer traction first.
How to write a business plan To attract venture capital investments
To write a great and attractive business plan, you need to pay attention to the following factors:
- Do some research on your rivals and prepare to name them. Show what makes you different and better.
- Prepare several versions of your business plan.
- Support each statement about your services or products with facts.
- Be realistic about the time and resources. Make sure not to underestimate the potential of your business.
Advantages of venture capital financing
Large sum of equity finance can be provided. Venture capital provides a business with an opportunity to grow and expand faster.
Without sufficient funds, a company cannot expand its operations. No significant growth can be achieved.
The right venture capital firm may serve as an important partner and resource. They may expose its portfolio companies to an established network.
The VC firm can offer expertise and guidance at the right time. They also help instill a healthy sense of urgency and discipline in the founders.
They bring wealth and expertise to the company. Venture capitalists have experience in building and expanding start-ups.
Their expertise and guidance are very useful. A member from the venture capital firm is often appointed to the management team of the company.
Connections are beneficial for startups that want to grow and become successful quickly.
Venture capitalists have large networks of connections in the business community across various industries.
They also provide valuable information, resources, and technical assistance to make a business successful.
The business does not stand the obligation to repay the money. If a business fails, there is no obligation to repay the venture capitalist investors.
Even though venture capitalists provide important funds to a business, they get an equity stake in return. A business startup that succeeds earns them decent amounts of profit.
Disadvantages of venture capital financing
- Loss of business autonomy and control
- Lengthy and complex funding process
- It is an uncertain form of financing
- Only long term benefits can be realized from venture capital investments
Venture capital exit options
There are various exit options for venture capital investors to cash out their investment:
Initial public offering (IPO)
Mergers and Acquisitions
Sale to other strategic investor
We can fund diverse projects such as;
Hospitality (hotels and resorts)
green energy projects
Logistics and transportation related developments
Residential and housing developments
ground up construction
commercial real estate
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