Venture Capital Funds - Angel Investing
Venture capital funds are investment funds that manage the money of investors who seek private equity stakes in startup and small- to medium-sized enterprises with strong growth potential. These investments are generally characterized as high-risk/high-return opportunities.
In the past, venture capital investments were only accessible to professional venture capitalists, although now accredited investors have a greater ability to take part in venture capital investments.
Q. What is Venture Capital Funding?
Venture capital is a type of equity financing that gives entrepreneurial or other small companies the ability to raise funding. Venture capital funds are private equity investment vehicles that seek to invest in firms that have high-risk/high-return profiles, based on a company's size, assets, and stage of product development investment vehicles that seek to invest in firms that have high-risk/high-return profiles, based on a company's size, assets, and stage of product development.
Venture capital funds differ from mutual funds and hedge funds in that they focus on a very specific type of early-stage investment. All firms that receive venture capital investments have high-growth potential, are risky, and have a long investment horizon. Venture capital funds take a more active role in their investments by providing guidance and often holding a board seat specific type of early-stage investment. All firms that receive venture capital investments have high-growth potential, are risky, and have a long investment horizon. Venture capital funds take a more active role in their investments by providing guidance and often holding a board seat.
Venture capital funds have portfolio returns that resemble a barbell approach to investing. Many of these funds make small bets on a wide variety of young startups, believing that at least one will achieve high growth and reward the fund with a comparatively large payout at the end. This allows the fund to mitigate the risk that some investments will fold.barbell approach to investing. Many of these funds make small bets on a wide variety of young startups, believing that at least one will achieve high growth and reward the fund with a comparatively large payout at the end. This allows the fund to mitigate the risk that some investments will fold.
Q. Structure of a Venture Capital Firm (Fund)
A venture capital fund is usually structured in the form of a partnership, where the venture capital firm (and its principals) serve as the general partners and the investors as the limited partners.
Limited partners may include insurance companies, pension funds, university endowment funds, and wealthy individuals, among others. Limited partners are passive investors.
All the partners have an ownership stake in the venture firm, but the general partners are actually hands-on. They may even serve as managers, advisors, or board representatives to the companies they invest in. These are called portfolio companies.
Profits from the disposition of investments made in the various portfolio companies are split between the general partners and limited partners. The general partners, who are also the private equity fund managers, usually get 20% of the profits as a performance incentive (often called a “carry”). They may also receive an annual management fee of up to 2% of the total capital invested.
The other 80% of any profits are divided equally (pro-rata) among the limited partners who invested in the fund.
Q. Characteristics of Venture Capital
1. Illiquid
Venture capital investments are usually long-term investments and are fairly illiquid compared to market-traded instruments (like stocks or bonds). Unlike publicly traded securities, VC investments don’t offer the option of a short-term payout. Long-term returns from venture capital investments depend largely on the success of the firm’s portfolio companies, which generate returns either by being acquired or through an IPO.
2. Long Term Investment Horizon
Venture capital investments feature a structural time lag between the initial investment and the final payout and usually have a time horizon of 10 years. The structural time lag increases the liquidity risk. Therefore, VC investments tend to offer very high (prospective) returns to compensate for this higher-than-normal liquidity risk.
3. Large discrepancy between Private and Public Valuation (Market valuation)
Unlike standard investment instruments that are traded on some organised exchange, VC investments are held by private funds. Thus, there is no way for any individual investor in the market to determine the value of the investment. The venture fund may also not completely understand how the market values its investment(s). This causes IPOs to be the subject of widespread speculation from both the buy-side and the sell-side.
4. Entrepreneurs lack full information about the market
The majority of venture capital investing is into innovative projects whose aim is to disrupt the market. Such projects offer potentially very high returns but also come with very high risks. As such, entrepreneurs and VC investors often work in the dark because no one else has done what they are trying to do.
5. Mismatch between entrepreneurs and VC investors
An entrepreneur and an investor may have very different objectives regarding a project. The entrepreneur may be concerned with the process (i.e., the means), whereas the investor may only be concerned with the return (i.e., the end). This can make discussions and general collaboration between entrepreneurs and investors challenging as they may have conflicting objectives around how the company should be run.
Q. How does a Venture Capital Fund Operates?
Venture capital investments are considered either seed capital, early-stage capital, or expansion-stage financing depending on the maturity of the business at the time of the investment. However, regardless of the investment stage, all venture capital funds operate in much the same way.
Venture capital investment is considered seed or early-stage capital.
Like all funds, venture capital funds must raise money prior to making any investments. A prospectus is given to potential investors of the fund who then commit money to that fund. All potential investors who make a commitment are called by the fund's operators and individual investment amounts are finalized.
From there, the venture capital fund seeks private equity investments that have the potential of generating positive returns for its investors. This normally means the fund's manager or managers review hundreds of business plans in search of potentially high-growth companies. The fund managers make investment decisions based on the prospectus and the expectations of the fund's investors. After an investment is made, the fund charges an annual management fee of around 2%, and some funds may not charge a fee. The management fees help pay for the salaries and expenses of the general partner. Sometimes, fees for large funds may only be charged on invested capital or decline after a certain number of years.
Q. How much Return does a Venture Capital Fund Makes?
Investors of a venture capital fund make returns when a portfolio company exits, either in an IPO or a merger and acquisition. If a profit is made off the exit, the fund also keeps a percentage of the profits—typically around 20%—in addition to the annual management fee. Though the expected return varies based on industry and risk profile, venture capital funds typically aim for a gross internal rate of return around 30%.
Q. How to become a Venture Capitalist ?
Venture Capital typically comes from institutional investors and high net worth individuals and is pooled together by dedicated investment firms.
It is the money provided by an outside investor to finance a new, growing, or troubled business. The venture capitalist provides the funding knowing that there’s a significant risk associated with the company’s future profits and cash flow. Capital is invested in exchange for an equity stake in the business rather than given as a loan.
Venture Capital is the most suitable option for funding a costly capital source for companies and most for businesses having large up-front capital requirements which have no other cheap alternatives. Software and other intellectual property are generally the most common cases whose value is unproven. That is why; Venture capital funding is most widespread in the fast-growing technology and biotechnology fields.
Q. What are the various Funding Stages in Venture Capital Funding?
The venture capital funding process typically involves four phases in the company’s development:
- The Seed Stage
- The Start-Up Stage
- The First Stage
- The Expansion Stage
- The Bridge Stage
The Seed Stage
Venture capital financing starts with the seed-stage when the company is often little more than an idea for a product or service that has the potential to develop into a successful business down the road. Entrepreneurs spend most of this stage convincing investors that their ideas represent a viable investment opportunity. Funding amounts in the seed stage are generally small, and are largely used for things like marketing research, product development, and business expansion, with the goal of creating a prototype to attract additional investors in later funding rounds.
The Start-Up Stage
In the startup stage, companies have typically completed research and development and devised a business plan, and are now ready to begin advertising and marketing their product or service to potential customers. Typically, the company has a prototype to show investors, but has not yet sold any products. At this stage, businesses need a larger infusion of cash to fine tune their products and services, expand their personnel, and conducting any remaining research necessary to support an official business launch.
The First Stage
Sometimes also called the “emerging stage,” first stage financing typically coincides with the company’s market launch, when the company is finally about to start seeing a profit. Funds from this phase of a venture capital financing typically go to actual product manufacturing and sales, as well as increased marketing. To achieve an official launch, businesses usually need a much bigger capital investment, so the funding amounts in this stage tend to be much higher than in previous stages.
The Expansion Stage
Also commonly referred to as the second or third stages, the expansion stage is when the company is seeing exponential growth and needs additional funding to keep up with the demands. Because the business likely already has a commercially viable product and is starting to see some profitability, venture capital funding in the emerging stage is largely used to grow the business even further through market expansion and product diversification.
The Bridge Stage
The final stage of venture capital financing, the bridge stage is when companies have reached maturity. Funding obtained here is typically used to support activities like mergers, acquisitions, or IPOs. The bridge state is essentially a transition to the company being a full-fledged, viable business. At this time, many investors choose to sell their shares and end their relationship with the company, often receiving a significant return on their investments.
An experienced business attorney can guide you through the different stages of venture capital financing and advise you on the best ways to secure funding for your company in its current stage.
Q. What are the different types of Venture Capital Funds in India?
The various types of venture capital are classified as per their applications at various stages of a business. The three principal types of venture capital are early stage financing, expansion financing and acquisition/buyout financing.
The venture capital funding procedure gets complete in six stages of financing corresponding to the periods of a company’s development
- Seed money: Low level financing for proving and fructifying a new idea
- Start-up: New firms needing funds for expenses related with marketing and product development
- First-Round: Manufacturing and early sales funding
- Second-Round: Operational capital given for early stage companies which are selling products, but not returning a profit
- Third-Round: Also known as Mezzanine financing, this is the money for expanding a newly beneficial company
- Fourth-Round: Also called bridge financing, 4th round is proposed for financing the "going public" process
A) Early Stage Financing:
Early stage financing has three sub divisions seed financing, start up financing and first stage financing.
- Seed financing is defined as a small amount that an entrepreneur receives for the purpose of being eligible for a start up loan.
- Start up financing is given to companies for the purpose of finishing the development of products and services.
- First Stage financing: Companies that have spent all their starting capital and need finance for beginning business activities at the full-scale are the major beneficiaries of the First Stage Financing.
B) Expansion Financing:
Expansion financing may be categorized into second-stage financing, bridge financing and third stage financing or mezzanine financing.
Second-stage financing is provided to companies for the purpose of beginning their expansion. It is also known as mezzanine financing. It is provided for the purpose of assisting a particular company to expand in a major way. Bridge financing may be provided as a short term interest only finance option as well as a form of monetary assistance to companies that employ the Initial Public Offers as a major business strategy.
C) Acquisition or Buyout Financing:
Acquisition or buyout financing is categorized into acquisition finance and management or leveraged buyout financing. Acquisition financing assists a company to acquire certain parts or an entire company. Management or leveraged buyout financing helps a particular management group to obtain a particular product of another company.
Q. What are the Advantages of Venture Capital?
- They bring wealth and expertise to the company
- Large sum of equity finance can be provided
- The business does not stand the obligation to repay the money
- In addition to capital, it provides valuable information, resources, technical assistance to make a business successful
Q. What are the Disadvantages of Venture Capital?
- As the investors become part owners, the autonomy and control of the founder is lost
- It is a lengthy and complex process
- It is an uncertain form of financing
- Benefit from such financing can be realized in long run only
