Venture capital is a very popular topic and on the forefront of everyone’s mind. It’s a staple in every entrepreneur’s playbook for raising capital. Today, I want to answer some of the most common questions I’m usually asked.
What is venture capital?
Venture capital is financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. For start-ups without access to capital markets, venture capital is an essential source of money. Risk is typically high for investors, but the downside for the startup is that these venture capitalists usually get a say in company decisions.
Entrepreneurs often turn to venture capitalists for money because their company is so new, unproven and risky and more traditional forms of financing, such as through banks, aren’t readily available. Though providing venture capital can be risky for the investors who put up the funds, the potential for above-average returns is an attractive payoff.
Not all venture capital investments take place when a company is first being founded. Venture capitalists can provide funding throughout the various stages of a company’s progression.
What is the typical venture capital process?
The first step for any business looking for venture capital is to submit a business plan to a venture capital firm. If interested in the proposal, the firm or the investor must then perform due diligence. This includes a thorough investigation of the business model, products, management, and operating history, etc. Once due diligence has been completed, the firm or the investor will pledge an investment in exchange for equity in the company. The firm or investor then takes an active role in the funded company. Because capital is typically provided in rounds, the firm or investor actively ensures the venture is meeting certain milestones before receiving another round of capital. The investor then exits the company after a period of time, typically 4 to 6 years after the initial investment, through a merger, acquisition or initial public offering (IPO).
Where does the capital come from?
Venture capital funds come from venture capital firms. They comprise professional investors who understand the intricacies of financing and building newly formed companies. The money that venture capital firms invest comes from a variety of sources, including private and public pension funds, endowment funds, foundations, corporations and wealthy individuals, both domestic and foreign. Those who invest money in venture capital funds are considered limited partners. While the venture capitalists are the general partners charged with managing the fund and working with the individual companies. The general partners take a very active role in working with the company’s founders and executives to ensure the company is growing in a profitable way.
Venture capital does not always take a monetary form; it can be provided in the form of technical or managerial expertise.
What are the different types of venture capital funding?
A) Early Stage Financing:
Early-stage financing has three sub-divisions seed financing, start-up financing, and first-stage financing.
- Seed financing is defined as a small amount that an entrepreneur receives for the purpose of being eligible for a start up loan.
- Start up financing is given to companies for the purpose of finishing the development of products and services.
- First Stage financing: Companies that have spent all their starting capital and need finance for beginning business activities at the full-scale are the major beneficiaries of the first stage financing.
B) Expansion Financing:
Expansion financing may be categorized into second-stage financing, bridge financing and third stage financing or mezzanine financing.
Second-stage financing is provided to companies for the purpose of beginning their expansion. It is also known as mezzanine financing. It is provided for the purpose of assisting a particular company to expand in a major way. Bridge financing may be provided as a short term interest only finance option, as well as a form of monetary assistance to companies that employ the Initial Public Offers as a major business strategy.
C) Buyout or Acquisition Financing:
Acquisition or buyout financing is categorized into acquisition finance and management or leveraged buyout financing. Acquisition financing assists a company to acquire certain parts or an entire company. Management or leveraged buyout financing helps a particular management group to obtain a particular product of another company.
Six stages of financing corresponding to the periods of a company’s development
- Seed money: Low-level financing for proving and fructifying a new idea
- Start-up: New firms needing funds for expenses related to marketing and product development
- First-Round: Manufacturing and early sales funding
- Second-Round: Operational capital given for early stage companies which are selling products, but not returning a profit
- Third-Round: Also known as Mezzanine financing, this is the money for expanding a newly beneficial company
- Fourth-Round: Also called bridge financing, 4th round is proposed for financing the “going public” process
Among the more famous companies to receive venture capital during their start-up periods are Facebook, Starbuck’s, eBay, Apple, Compaq, Intel, Microsoft and Google.
I’ll be expanding on the subject of venture capital in future issues.
Until next time,