Introduction to Venture Capital
Venture Capital is a form of financing provided to early-stage companies that are believed to have a high-growth potential. The VC (Venture Capital) funds invest in small startups (mainly from high technology industry) in exchange for equity ownership.
For those small companies that have no access to capital markets or no credit history to secure a bank loan, venture capital is a major source of financing. Investors participate in the company’s decision-making process most of the time.
The investments pooled in the Venture Capital fund come from different sources, including wealthy individuals, insurance companies, pension funds, foundations, university financial endowments, etc.
The partners that have an ownership in the fund are known as limited partners, and the VC controlling the fund is known as a general partner. Typically, nearly 20 percent of the generated income is distributed to the company managing the fund and the rest is provided to limited partners.
Venture capital firms can be formed as partnerships and, in the case of US, LLCs also, where the general partners are the managers of the firm. Taking into account the high level of risk, Venture Capitalist are very selective in picking companies to invest in. The startups have to “convince” the investors to provide financing based on the high growth potential of their company.
Venture capitalists generally have a time horizon of three to seven years after which they exit by selling its stakes in the company through an IPO, merger, acquisition, etc.
Generally, a venture capital is provided not in a lump-sum but in several rounds, with a certain criteria/requirements before every round for providing additional financing.
We can separate six stages of typical venture financing, depending on the development level of the company.
- Seed funding: The earliest round of financing typically in the idea or conceptual stage. The seed funds are generally utilized on research & development costs or on covering operating expenses until the company starts to generate revenue. It is often provided by angel investors or via crowdfunding.
- Start-up: Companies in their early stage of development which need financing to cover expenses associated with marketing and product development.
- Growth (Series A round): A stage when Venture Capital investments are provided. In this stage, the companies have usually developed their product, know the market they are operating and expect to utilize the funds for improving the distribution system, establishing a business model, etc.
- Second-Round (Series B round): In this stage, the companies generally have a working business model, are selling products but not yet generating income. The funds are generally utilized for working capital expenditures.
- Expansion (Mezzanine financing): These expansion funds for newly profitable companies represent a hybrid of debt and equity financing.
- The exit of a venture capitalist: Generally VCs exit through IPO, mergers, or acquisitions.
Venture Capital funds expansion was seen with the growth of Silicon Valley. Technology giants such as Apple, Cisco, Microsoft, were able to grow through the venture funding. However, the venture capital firms started posting losses during the mid-80s to early 90s as valuations for startups companies collapsed.
A new growth stage that began from 1995 and lasted through the Internet bubble in 2000, led to the creation of companies such as Google, Yahoo, Amazon, eBay, etc.
This expansion of internet sector reached its climax in March 2000, when Nasdaq hit 5,132.52 points, but collapse thereafter as many tech companies faced financial difficulties forcing VCs to sell their investments. Since then, Venture Capital started growing with $47 billion invested in startups as of 2014.