Sneha is the CEO of a startup that specializes in digital wallet services. Even though she has a brilliant idea to pitch for scaling up her organization, she finds it difficult to get investors on board. For weeks on end, Sneha struggles with how to get funding for her startup.
Sneha’s startup is barely a year old and Sneha herself lacks experience in the sector. A series of banks refuse to fund the startup before a venture capital organization finally takes up the mantle of investment.
According to Smriti, the chief investment manager of the venture capital organization investing in Sneha’s startup, the latter has the necessary vision to lead a successful business. Smriti calculates that within five years Sneha and her team can take their organization to among the top three in the national sector. Smriti is also impressed by Sneha’s understanding of one of the key aspects of running a startup: “what is financial management and its functions?”. All this convinces Smriti that her investment is worth making and will yield substantial returns.
After a six-year collaboration, both Smriti and Sneha’s startup achieve their respective goals, putting forth a successful example of the impact of venture capital.
What Is Venture Capital (VC)?
Venture capital is concerned with providing financing for organizations and acting as an investment vehicle for individuals and institutional investors. The basis of venture capital investments involves investing capital in startups with long-term growth potential. The capital invested is called venture capital and the investors are called venture capitalists. Venture capital is an effective and increasingly popular way for organizations, especially those in their formative years, to receive funds in the short-term and for investors to grow their wealth in the long term.
What is venture capital financing?
This refers to the investment made by venture capitalists in emerging organizations. The financing can be provided at different stages of an organization’s evolution, although it generally includes early and seed round funding.
Why do venture capitalists focus on emerging organizations when they’re looking to invest even though these investments are risky and illiquid? This is because these organizations also have the greatest potential to offer impressive returns after a few years.
VC organizations finance new organizations by equity participation and capital gains or by participating in debentures or extending conditional loans to the organizations. It’s important to note that since venture capital is concerned with helping an organization grow, the investment doesn’t have to be just monetary in form. It can also be provided in the form of technical or managerial expertise.
Following the Second World War, venture capital evolved from a niche activity into a well-structured and sophisticated industry that has multiple players and stakeholders contributing in their own ways to accelerate innovation.
How Do Venture Capitalists Differ From Angel Investors?
Angel investors are individual investors, usually high net worth individuals (HNWs), who have amassed their wealth through a variety of sources and are interested in investing in an emerging organization. Most angel investors tend to be entrepreneurs or executives who’ve recently retired from managing their own organizations, or in some cases, their business empires.
While both venture capitalists and angel investors provide money to startups, venture capital organizations or venture capitalists are typically professional investors who invest in a broad portfolio of new organizations and lend hands-on guidance as part of their investment. They may also leverage their carefully nurtured professional networks to help new organizations. On the other hand, angel investors invest more as a hobby or as a side-project and may not offer as much expertise as venture capital organizations. As a market trend, angel investors also invest earlier than venture capitalists in emerging organizations.
In the context of understanding “what is venture capital financing?” and its differences with apparently similar kinds of investments, there’s an important difference to be noted. This concerns the difference between venture capital and other private equity deals. While venture capital tends to focus on emerging organizations in need of substantial funding for the first time, private equity is more likely to fund larger, more recognized organizations that are looking for an equity infusion or an opportunity to distribute ownership stakes.
Advantages Of Venture Capital
Before proceeding to evaluate how venture capital works or the technical nuances venture capital is concerned with, it’s time to take a look at the several advantages offered by venture capital:
- As most bankers are skeptical to lend money to an organization in its early stages due to an absence of assets that can be held as collateral, venture capital provides a great replacement as a source of initial funding for the organization
- From the perspective of venture capitalists, early investment helps secure some extent of control over an organization and in most cases the investment also allows venture capitalists to have a say in the organization’s growth
- Investment from venture capital through large sums of equity finance doesn’t impose an obligation to repay for startups while at the same time boosting their growth
- Venture capital organizations are well-equipped to analyze early-stage startups as their methods go beyond financial statements such as product and market-size estimates and performing due diligence on the startup’s founding team
- As equities are uncapped, there’s no upper limit to how much an investor can earn through venture capital
How Venture Capital Works
What is venture capital funding and how does it work?
To understand how venture capital works you need to understand the different stages an organization goes through from interesting investors to collaborating with them such that both parties make smarter decisions.
The first step for any organization looking for venture capital is to submit a business plan to potential investors. Should an investor be interested, they must then perform a thorough background check on the organization, or what is technically known as due diligence. This includes a comprehensive investigation of the organization’s business model, products, management and operating history.
Once due diligence is complete, an investor will pledge an investment of capital in exchange for equity in the organization. The capital may be provided all at once, but is usually supplied in rounds. In the meantime, the investor takes an active role in advising and monitoring the progress of the organization before supplying additional funds.
After a certain period of time, typically somewhere between four and six years after the initial investment, the investor makes a call to exit the organization. This exit can be worked out by initiating a merger, an acquisition or an initial public offering (IPO).
Effectively, the process of how venture capital works is about focusing on how an organization grows in a high-growth industry. Intelligent investors avoid both the early stages of an organization’s life cycle, when technologies are uncertain and market needs are unknown, as well as the later stages when shakeouts and consolidations are likely and growth has slackened.
How Much Risk Does Venture Capital Involve?
According to conventional wisdom, for every 10 startups that a VC organization invests in, three or four end up failing completely. Another three or four either lose some of the money that was invested or just about return the original investment, whereas just one or two produce substantial returns. But the key factor about these ratios is that the substantial returns from one or two investments can easily cover the losses incurred elsewhere.
At the same time, as a venture capitalist, it’s vital to proceed with caution. Venture capitalists with little experience don’t and shouldn’t make large investments early on. Impulsive investments can result in the entire amount of money being lost.
Depending on the stage an organization is at, its prospects, the amount that’s being invested and the relationship between the investors and the founders, venture capital organizations generally receive between 25 and 50% of a new organization’s ownership. These aren’t stakes to be trifled with.
Venture capital organizations also protect themselves from risk by co-investing with other organizations. Conventionally, there will be a “lead” investor and several “followers”. It’s an exception, and not the norm, for one venture capital organization to finance an individual organization entirely. Rather, venture capitalists prefer to have two or three groups involved in most stages of financing. The product of such relationships is portfolio diversification, which is the ability to invest in more deals per dollar of invested capital.
Mastering Venture Capital Management
Getting decisions right as part of venture capital is about harnessing the right instincts about investments. How do you build these instincts? With the help of Harappa’s Commercial Acumen pathway, which is designed for you to make astute financial decisions, manage your resources optimally and drive value. Through this pathway, you’ll receive insights from a world-class faculty on balancing costs while retaining quality and speed, driving win-win outcomes and achieving goals within a budget besides navigating frameworks such as The Good-Cheap-Fast Rule as well as the Negotiation Pie.
Sign up for the Commercial Acumen pathway without any further ado and take the all-important step toward mastering venture capital management.