Lets take deep dive in Venture Capitalists for startup financing
Concept, Characteristics, Advantages, Stages of funding, VC Investment Process & methods of Venture Capitalists
What is Venture Capitalists
Venture capital means funds made available for startup firms and small businesses with exceptional growth potential. Venture capital is money provided by professionals who alongside management invest in young, rapidly growing companies that have the potential to develop into significant economic contributors.
Venture Capitalists generally:
Finance new and rapidly growing companies
Purchase equity securities
Assist in the development of new products or services
Add value to the company through active participation.
Characteristics of Venture Capital Financing
Long time horizon: The fund would invest with a long time horizon in mind. Minimum period of investment would be 3 years and maximum period can be 10 years.
Lack of liquidity: When VC invests, it takes into account the liquidity factor. It assumes that there would be less liquidity on the equity it gets and accordingly it would be investing in that format. They adjust this liquidity premium against the price and required return.
High Risk: VC would not hesitate to take risk. It works on principle of high risk and high return. So, high risk would not eliminate the investment choice for a venture capital.
Equity Participation: Most of the time, VC would be investing in the form of equity of a company. This would help the VC participate in the management and help the company grow. Besides, a lot of board decisions can be supervised by the VC if they participate in the equity of a company.
Advantages of bringing VC in the company
It injects long- term equity finance which provides a solid capital base for future growth.
The venture capitalist is a business partner, sharing both the risks and rewards. Venture capitalists are rewarded with business success and capital gain.
The venture capitalist is able to provide practical advice and assistance to the company based on past experience with other companies which were in similar situations.
The venture capitalist also has a network of contacts in many areas that can add value to the company.
The venture capitalist may be capable of providing additional rounds of funding should it be required to finance growth.
Venture capitalists are experienced in the process of preparing a company for an initial public offering (IPO) of its shares onto the stock exchanges or overseas stock exchange such as NASDAQ.
They can also facilitate a trade sale.
Stages of funding for VC
Seed Money: Low level financing needed to prove a new idea.
Start-up: Early stage firms that need funding for expenses associated with marketing and product development.
First-Round: Early sales and manufacturing funds.
Second-Round: Working capital for early stage companies that are selling product, but not yet turning in a profit.
Third Round: Also called Mezzanine financing, this is expansion money for a newly profitable company.
Fourth-Round: Also called bridge financing, it is intended to finance the “going public” process.
VC Investment Process
The entire VC Investment process can be segregated into the following steps,
Deal Origination: VC operates directly or through intermediaries. Mainly many practicing Chartered Accountants would work as intermediary and through them VC gets the deal. Before sourcing the deal, the VC would inform the intermediary or its employees about the following so that the sourcing entity does not waste time :
Sector focus
Stages of business focus
Promoter focus
Turn over focus
Screening: Once the deal is sourced the same would be sent for screening by the VC. The screening is generally carried out by a committee consisting of senior level people of the VC. Once the screening happens, it would select the company for further processing.
Due Diligence: The screening decision would take place based on the information provided by the company. Once the decision is taken to proceed further, the VC would now carry out due diligence. This is mainly the process by which the VC would try to verify the veracity of the documents taken. This is generally handled by external bodies, mainly renowned consultants. The fees of due diligence are generally paid by the VC. However, in many cases, this can be shared between the investor (VC) and Investee (the company) depending on the veracity of the document agreement.
Deal Structuring: Once the case passes through the due diligence it would now go through the deal structuring. The deal is structured in such a way that both parties win. In many cases, the convertible structure is brought in to ensure that the promoter retains the right to buy back the share. Besides, in many structures to facilitate the exit, the VC may put a condition that promoter has also to sell part of its stake along with the VC. Such a clause is called tag- along clause.
Post Investment Activity: In this section, the VC nominates its nominee in the board of the company. The company has to adhere to certain guidelines like strong MIS, strong budgeting system, strong corporate governance and other covenants of the VC and periodically keep the VC updated about certain mile-stones. If milestone has not been met the company has to give explanation to the VC. Besides, VC would also ensure that professional management is set up in the company.
Exit plan: At the time of investing, the VC would ask the promoter or company to spell out in detail the exit plan. Mainly, exit happens in two ways: one way is ‘sell to third party’. This sale can be in the form of IPO or Private Placement to other VCs. The second way to exit is that promoter would give a buy back commitment at a pre agreed rate (generally between IRR of 18% to 25%). In case the exit is not happening in the form of IPO or third party sell, the promoter would buy back. In many deals, the promoter buyback is the first refusal method adopted i.e. the promoter would get the first right of buyback.
Methods of Venture Capital Financing
Equity financing: The venture capital undertakings generally requires funds for a longer period but may not be able to provide returns to the investors during the initial stages. Therefore, the venture capital finance is generally provided by way of equity share capital. The equity contribution of venture capital firm does not exceed 49% of the total equity capital of venture capital undertakings so that the effective control and ownership remains with the entrepreneur.
Conditional Loan: A conditional loan is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans. In India Venture Capital Financers charge royalty ranging between 2 to 15 percent; actual rate depends on other factors of the venture such as gestation period, cash flow patterns, riskiness and other factors of the enterprise. Some Venture Capital Financers give a choice to the enterprise of paying a high rate of interest (which could be well above 20 percent) instead of royalty on sales once it becomes commercially sound.
Income Note: It is a hybrid security which combines the features of both conventional loan and conditional loan. The entrepreneur has to pay both interest and royalty on sales but at substantially low rates. IDBI’s Venture Capital Fund provides funding equal to 80-87.5% of the projects cost for commercial application of indigenous technology or adopting imported technology to domestic applications.
Participating Debenture: Such security carries charges in three phases - in the start up phase, no interest is charged, next stage a. low rate of interest is charged up to a particular level of operations, after that, a high rate of interest is required to be paid.
Bottom line
Venture capitalist is one of the key option to raise funding for startup as Entrepreneur gets funding and investor gets return which is win - win situation for both.