Venture Capital (VC) is a form of private equity as a financial backing that investors provide to start-up companies that they believe will have exceptional growth over the long run. This venture capital is usually coming from institutional banks, financial institutions or even high net worth individuals and wealthy investors. For companies that are in the early stages, it is becoming extremely popular.
Start-ups who usually need this support are considered to be risky investments. However, investors willing to finance them believe that the reward is worth taking the risk since it could offer an attractive payoff. Moreover, investors can actually get equity in the company, which means they have a saying company’s decisions. Venture capital does not always come in monetary forms but it can also be provided in the form of managerial expertise to help rebuild or restructure the company’s approach.
As for any other business looking to get funding from elsewhere is to have a business plan. This business plan is usually submitted to a venture capital firm or to a high net worth individual. If the firm or individual investors are interested in the business plan, they should then start their own due diligence (DD) that will include a thorough investigation into the company’s profile. DD’s usually include the team (management) of the company and their backgrounds to check if they fit the position they have been given, business model, operations, financials, performance, product and other.
Venture capitalists are usually coming from an analytical background since they have the knowledge to understand if the numbers, performance, operations, etc. look good and if they can be improved. It is very important to have a complete check before they invest in a risky company that might not succeed. A venture capitalist that specializes in real estate might have prior experience in the real estate industry as an analyst of the over market, house pricing, etc.
After this stage is done, the investor will suggest his investment in the company in exchange for an equity stake. The funds are transferred in various ways such as all at once, or in installments. However, it is most common that investors will pay in rounds since it is easier for them to monitor and keep track of the progress before releasing additional funds.
The last stage is the exit. Investors exit the company after few years, by initiating a merger, acquisition, or Initial Public Offering (IPO).
As in any company that is just starting there are risks of never making it, failing, not being profitable, bad management, and many other questions that no one knows how to answer which is why start-ups are naturally risky investments. Companies at their more mature stages, are slowly becoming safer, more stable, and they break even to pave the way to profitability.
On the other hand, start-ups have more potential to grow and expand. The common rule suggests that every 10 start-ups three to four will fail completely, meaning that investors will lose their initial investment. Another three to four start-ups will lose some money or just return the original investment and lastly, one or two start-ups will produce substantial returns.
Entrepreneurs, innovative minds and spirits are the drivers of this capitalist economy. New businesses are often very risky therefore they seek additional sources of funding in order to spread the risk of failure. In return for taking on this risk, investors obtain equity stakes and voting rights.
Venture Capital gives the company an opportunity to expand that would have not been possible in any other way such as bank loans or other sources. Bank loans require collateral and of course, carry the obligation to repay them. On the other hand, if venture capital investors are ready to undertake the risk of losing their money in exchange for a long-term equity stake in the startup. Therefore, venture capital is preferable to bank loans since it is also carrying the business skills and expert guidance of the venture capitalists.
Investors do come from a very experienced field and usually know what the company needs to do in order to succeed, which is why they are willing to invest in it. They usually carry the appropriate knowledge to change operations and guide management’s decisions by building strategies, resources, etc.
As mentioned above, venture capitalists have huge network connections since most of them have experience in the industry. These connections can be very advantageous for the startup and open new doors and partnerships.
There is no obligation to repay the venture capitalist investors if the start-up fails or shuts down. Hence, venture funding is essential for start-ups. It does not leave the start-up with the burden to pay back as is the case with bank loans.
Since Venture Capitalists provide huge capital to start-ups in return for a stake in the company, if the company succeeds the profits can be great. The VC will usually be part of the Board of Directors which gives them the right to vote and to decide on important matters. If the VC has a different opinion from the start-up founder this will be chaotic and can have many implications.
Some VC may put stress on companies to deliver high ROI within the very first years of the funding in order to get their gains and leave. However, this is not always good for the company since it might lead it to financial distress, or if it needs a longer period of time to generate returns.
A VC might decide to leave the company after 3 or 5 years of the investment since their primary focus is to make capital gains and leave.
In order for the investor to leave the company, there must be some kind of merger, acquisition or a direct IPO. In the case of the investor wanting to leave the company very early, it may pressurize the owner to list the company. This ultimately listing could result in under-valuation of the company’s shares.
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