Venture Capital Funding – What Is It?
Venture Capital funding is the process of providing finance to start-up companies, or businesses planning expansion, by a group of high net worth individuals, or institutions, who are in possession of great amounts of ready capital. Investments are made through venture capital (VC) firms in return for company shares, and promise of substantial gain on invested capital.
Venture capital funding is provided to only selected projects, typically ventures that are capable of giving good returns on investments and those that clarify an exit event after a period of 3 to 7 years. High growth potential companies are likely to attract venture capital funding more than companies without any well-defined plan for expansion. Owing to various other factors as well, venture capitalists may ultimately invest in only one out of 400 venture projects.
The Stages of Venture Capital Funding
Venture capitalists are expected to assume entrepreneurial roles in the companies they invest in. They are required to help companies through stages of idea generation, business launch and growth, and reach favourable valuations.
Venture capital funding is provided as a six-stage financing that corresponds with the developmental stages of a company:
- Seed Money: Often provided by an affluent individual (‘angel investor’) with capital, the seed-money or low-level financing helps take a new idea forward.
- Start-up: Given to companies at start-up, venture capital funding covers expenses for product marketing and development.
- First round: Following product development, venture capital funding takes care of a company’s early sales and manufacturing costs.
- Second round: Most companies at this stage are yet to make profits from sales. Venture capital funding allows companies to continue their product manufacturing and marketing processes.
- Third round: Once a company starts profiting from sales, venture capital funding allows it to expand. This is also called ‘mezzanine’ financing.
- Fourth round: Availability of funds encourages companies to ‘go public’. This is known as ‘bridge’ financing.
Venture Capital Funding- How VCs Decide On Ventures
A good business plan is one that includes the following:
- Strong business ideas
- Efficient management
- Passionate founders with a commitment to excellence
- Annual minimum returns in excess of 40%
- Good potential for growth and profitability before end of the venture capital funding cycle
Before investing in new venture projects, venture capitalists will perform the following evaluation processes:
Screening: The initial screening process involves a brief overview of a company’s business plans. This is followed by assessing the business proposal to see if it will fit within a venture capitalist’s area of expertise. Venture capitalists may limit their investment to projects with which they are familiar in terms of the market, product, and use of technology. The amount of venture capital funding required, the stage at which the company needs financing and its location, are broad factors that influence investment.
Once a company’s business proposal has successfully cleared the initial screening round, VC firms evaluate its detailed business plans. Entrepreneurs must maintain clarity in the presentation of business strategies to venture capitalists. They must cover details like market research, production plans, profit generation and expansion to attract venture capital funding.
Venture capital firms are primarily interested in maximum gain on capital investment. A company’s returns and profits must match or exceed a VC firm’s expectations. The screening process helps venture capitalists decide which companies to help with Venture Capital funding. Companies with innovative ideas and promising growth plans are most likely to acquire venture capital funding for their businesses.
Due Diligence: Before releasing capital funds, the venture capitalists usually verify the accuracy of business plans and statements made by a company’s entrepreneur. Due diligence is important as investments take 3 to 7 years to yield returns.
When conducting legal due diligence, the lawyers of the VC firms verify company documents provided to them. Such documents include the company’s articles of association and memorandum, important patents, contracts, copyrights, etc.
The business due diligence process involves the evaluation of the quality of business and employees with regard to investment requests by the venture capitalists.
Many theorists believe that VC firms prefer an average team with a strong idea to an excellent team with an average idea, to work on ventures. Some opine that the integrity of professionals working in a team is an important criterion for providing venture capital funding. Research has proved that almost 60% projects with good business ideas are rejected owing to incapable entrepreneurship.
The other deciding factor is the quality of business itself. Venture capitalists seek business proposals with unique and distinct competitive advantage. They also look at the market potential of ideas. Unfortunately, for many young, start-up companies, business plans often lack details and they lose out on venture capital funding for their businesses because of this.
When applying for venture capital funding, a clearly defined exit mode is the most important feature a business proposal should include. Venture capitalists appreciate clarity of the exit event and returns when they are investing capital in a business. Profits distinguish a VC firm’s success portfolio from its competitors.