Venture Capital Funds
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.
Understanding Venture Capital Funds
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.
Operating a Venture Capital Fund
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.
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.
Venture Capital Fund Returns
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%.
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.
THE FUNDING PROCESS: Approaching a Venture Capital for funding as a Company
The venture capital funding process typically involves four phases in the company’s development:
- Idea Generation
- Ramp Up
Step 1: Idea generation and submission of the Business Plan
The initial step in approaching a Venture Capital is to submit a business plan. The plan should include the below points:
- There should be an executive summary of the business proposal
- Description of the opportunity and the market potential and size
- Review on the existing and expected competitive scenario
- Detailed financial projections
- Details of the management of the company
There is detailed analysis done of the submitted plan, by the Venture Capital to decide whether to take up the project or no.
Step 2: Introductory Meeting
Once the preliminary study is done by the VC and they find the project as per their preferences, there is a one-to-one meeting that is called for discussing the project in detail. After the meeting the VC finally decides whether or not to move forward to the due diligence stage of the process.
Step 3: Due Diligence
The due diligence phase varies depending upon the nature of the business proposal. This process involves solving of queries related to customer references, product and business strategy evaluations, management interviews, and other such exchanges of information during this time period.
Step 4: Term Sheets and Funding
If the due diligence phase is satisfactory, the VC offers a term sheet, which is a non-binding document explaining the basic terms and conditions of the investment agreement. The term sheet is generally negotiable and must be agreed upon by all parties, after which on completion of legal documents and legal due diligence, funds are made available.
Types of Venture Capital funding
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 calledbridge 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.
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
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