Venture Capital 101: Function, Types, Features & How does fund raising work?
How does the concept of venture capital work?
Venture capital is in simple terms, an influx of cash in a business, startup or a concept. Those who invest money also buy shares in the company and become financial business partners, better known as investors.
Venture capital investments are also called risk capital as there is a potential to lose money if the new venture does not succeed.
Now, why would any individual invest in a potential risk? That’s because they conceive this risk as an opportunity. Each investor has their own style & parameters to evaluate and theoretically mitigate risks in their investment.
But the end goal, as Kevin O’Leary famously says:
“My goal is to pour gasoline to your fire in the form of money.”
Venture capital is typically obtained from venture capitalists (VCs), venture capital firm (VCFs) and institutional investors.
Venture capital is not a long-term play for any disciplined investor. In fact, not all investors are even active in the running of the venture they invest in.
The crux of the concept of venture capital is to invest money to buy a certain percentage of equity in the company so that it can be eventually sold-off to another company at a multiple of the current valuation of the venture or to have a profitable exit when the company files for an IPO. Mind you, both of these are possible only when the venture works out.
Features of Venture Capital
Venture capital has some general characteristics, as stated below
High risk: It requires making investments in new or highly risky projects with the incentive of earning high rates of return of the investment made.
Long term investment: Venture capital funding of a company is a long-term investment and takes a significant amount of time to recover investments made in securities.
Equity participation and gains: It involves actual or potential equity participation wherein the objective is to make gains by selling shares in the company when it becomes profitable.
Illiquid investment: Investment made in the company is not subject to repayment on demand and does not have a fixed repayment schedule.
Participation in management: Venture capitalists may take an interest and have a say in the management of the companies which they have funded.
How does fundraising work?
Venture capital funding process for a company involves different phases:
Idea Generation & Submission of a Business Plan
The founders of the business will first submit a business plan detailing the business idea; the target market as well as a strategy on how to bring in revenue and grow the business. The business plan submitted must include:
- Executive summary of the business proposal
- Description of the opportunity and the potential market size
- Information on how the company will be managed
- Explore various revenue streams and opportunities
- Forecast financial projections and review the competitive scenario
Meeting among the parties
After doing a detailed study and reviewing the business plan, the venture capitalists (VCs) or the venture capital institutions call for a meeting with the business founders to have a detailed discussion. Post this meeting, a decision is taken by the VCs on whether to move on to the next stage.
In this stage, queries are solved regarding product and business strategy evaluations, customer references and management interviews. Other relevant information is also exchanged between the parties.
Term sheets and funding
After due diligence is done, a term sheet is introduced by the VC. This is a non-binding and negotiable document explaining the terms and conditions for the investment agreement between the two parties. Once the term sheet has been finalized, legal documents are prepared and legal due diligence is carried out. Funds are then made available to the business.
Types of Venture Capital
There are different types of venture capital funding and the purpose of the funding varies at different stages. Funding is provided to a business depending on which stage it has reached and is as follows:
- Pre-seed capital: This stage is not funded by venture capital but by the business founders and their supporters to get the company operations started.
- Seed capital: Investment made at this stage is small and may be used to cover set-up costs, fund market research, product development and pinpoint target demographic.
- Start-up capital: Funding would cover additional market research, recruitment, key management and finalizing the product or service being offered.
- Early-stage capital: At this point, funding is needed to increase sales, improve productivity and help a business run more efficiently.
- Expansion capital: A well-established business need to grow further. Funding would be necessary to enter new markets and increase marketing efforts.
- Late-stage capital: Once the business is successful and brings inadequate revenue, funds would be required to increase marketing and working capital.
- Bridge financing: Also referred to as IPO stage and is the last stage of funding before exit. The business looks to form mergers or acquisitions. The company may also look to public financing by offering stocks in return.
We had previously covered the funding history of Swiggy. Each of Swiggy’s funding rounds was designed according to the progress that Swiggy has made then as a venture. As an example, can you map each of these series rounds to the type of venture capital Swiggy secured according to the Swiggy’s size? Let me know in the comments below.