What is Venture Capital Financing? Process, Stages, Features

What is Venture Capital Financing?

In a narrow sense venture capital financing refers to, investment in new and tried enterprises that are lacking a stable record of growth.

In a broader sense, venture capital refers to the commitment of capital as shareholding for the formulation and setting up of small firms specializing in new ideas or new technologies.

In simple words, Venture capital is money provided by individual investors or entities seeking a high return on their investment in privately owned business. In order to get those high returns, venture investors are willing to accept a relatively high degree of risk of loss of their investment.

It is also known as seed capital or private capital. Venture capital is mostly used to help businesses that have high potential for growth and related with technology oriented. Venture capital funds are used primarily for companies who may not have sufficient operating history to qualify for traditional loans through a bank.

The organization that provides venture capital us called venture capitalist or venture capital fund.

According to SEBI (Venture Capital Funds) Regulations, 1996, a venture capital fund is a fund establishes in the form of a trust or company including body corporate and registered under this regulation that has a dedicated pool of capital raised in a manner specified in the regulations and invests in accordance with these regulations.

These Venture capital funds typically invest in business enterprises they anticipate being sold either to the public or to larger firms within the next few years of their start.

Business enterprises they will consider investing in usually have the following features:

• Rapid, steady sales growth
  
• Proprietary new technology or dominant position in an emerging market
  
• A sound management team
  
• The potential for being acquired by a larger company or taken public in a stock offering

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Features of Venture Capital

Under venture capital finance, the venture capitalist provides financial support to a business which is in early stage of development, though it involves risk but at the same time is has the potential for generating abnormal returns for venture capitalist.

Venture capital combines the qualities of a banker, stock market investor and entrepreneur in one. The main objective of venture capitalist is to get abnormal or exceptional returns on their investment.

Some of the features of venture capital financing are as follows:

• High Degrees of Risk: Venture capital generally represents investment in a highly risky project with the objective of earning a high rate of return.
  
  
• Equity Participation: Venture capital financing is an actual or potential equity participation wherein the objective of venture capitalist is to make capital gain by selling the shares once the firm becomes profitable.
  
  
• Participation in Management: Venture capital involves not only investing money but also active participation in the management of the company by the venture capitalist.
  
  
• Investment in Small and relatively new companies: Venture Capital Financing is usually done for companies which are small level or medium level and also relatively newly formed companies are the preferred choice of venture capitalist.
  
  
• Long Term Investment: Venture capital financing is a long term investment. It generally takes a long period to encash the investment in securities made by the venture capitalists.

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Stages of Venture Capital Financing

There are five distinct stages of venture capital funding:

• Seed or early stage
• Growth stage
• Start-up stage
• Late stage
• Buyouts/recapitalizations.

Seed or Early Stage

The first stage of a business is known as seed- capital stage. Venture capitalists are more often interested in providing seed finance i.e. making provision of very small amounts for finance needed to turn into a business. Research and development activities are required to be undertaken before a product is to be launched.

External finance is often required by the entrepreneur during the development of the product. The financial risk increases progressively as the research phase moves into the development phase, where a sample of the product is tested before it is finally commercialized “venture capitalists/ firms/ funds are always ready to undertake risks and make investments in such R & D projects promising higher returns in future.

Start-up Stage

Newly formed companies without significant operating history are considered to be in the start-up stage. Most venture capitalist fund this stage of a company’s development with their own funds as well as investments from angel investors.

Angels are wealthy individuals, friends, or family members that personally invest in a company. Angels are the most common source of first round funding for technology businesses. They often will back companies that are at the concept stage and have a limited track record with respect to customers and revenue. These investors tend to invest only in local companies or for people that they already know personally.

Second Round Financing

It refers to the stage when product has already been launched in the market but has not earned enough profits to attract new investors. Additional funds are needed at this stage to meet the growing needs of business. Venture capital funds (VCF) provide larger funds at this stage than at other early stage financing in the form of debt. The time scale of investment is usually three to seven years.

Expansion Stage

Venture capitalists perceive low risk in ventures requiring finance for expansion purposes either by growth implying bigger factory, large warehouse, new factories, new products or new markets or through purchase of existing businesses. The time frame of investment is usually from one to three years.

At this stage, it may be necessary to finance the additional working capital requirement in view of expansion of business activities. This stage of financing is also known as bridge financing. Bridge financing is a short- term financing provided until long term financing is arranged.

Later Stage Financing

This is the stage at which the project has established itself and business wants to expand further. Those established businesses which require additional financial support but cannot raise capital through public issue approach venture capital funds for financing expansion, buyouts and turnarounds or for development capital.

• Development Capital: It refers to the financing of an enterprise which has overcome the highly risky stage and has recorded profits but cannot go public, thus needs financial support.
  
  Funds are needed for the purchase of new equipment/ plant, expansion of marketing and distributing facilities, launching of product into new regions and so on. The time scale of investment is usually one to three years and falls in medium risk category.
  
  
  
• Buy Outs: It refers to the transfer of management control by creating a separate business by separating it from their existing owners. It may be of two types i.e. Management buyouts (MBOs) and Management buy-ins (MBIs).
  
  In Management Buyouts (MBOs) venture capital institutions provide funds to enable the current operating management/ investors to acquire an existing product line/business.
  
  On the other hand, Management Buy-ins is funds provided to enable an outside group of manager(s) to buy an existing company. It involves three parties: a management team, a target company and an investor.
  
  MBIs are more risky than MBOs and hence are less popular because it is difficult for new management to assess the actual potential of the target company. Usually, MBIs are able to target the weaker or under-performing companies.
  
  
  
• Turnaround: Is a situation in which a sick company recovers its ground. Such form of venture capital financing involves medium to high risk and a time scale of three to five years. It involves buying the control of a sick company which requires very specialized skills.
  
  It may require rescheduling of all the company’s borrowings, change in management or even a change in ownership. A very active “hands on” approach is required in the initial crisis period where the venture capitalists may appoint its own chairman or nominate its directors on the board.

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Process of Venture Capital

Once the company has decided to take the venture capital funding for your business. It is very important for it to follow the appropriate process to raise funds.

In India, the typical venture capital fund raising process involves the following steps:

Preparation of a business plan

The process of obtaining venture capital financing starts with the finalisation of business plan. Normally, a venture capitalist invests in an innovative business that has lots of potential to grow in the future. Therefore, before approaching any venture capitalist, you should have a properly drafted business plan that includes at least the following:

• A description of the opportunity and market size;
• Profiles of the management team;
• A review of the competitive landscape and solutions;
• Detailed financial projections
• A capitalisation table and
• An executive summary of the business proposal along with the business plan.

Identification of the right venture capitalist

Once the detailed business plan is ready, the next step is to identify a suitable venture capital institute for funding. Selection of a venture capital firm depends on the ability and experience of the venture capitalist to deal in the industry concerned.

Meeting the Venture Capitalist

The investment banker approaches venture capitalists and starts making presentations to them. The purpose of these presentations is to bring the promoters of the company and the investors face-to-face. In the follow-up meetings, the company tries to convince the investors about the investment.

Due diligence

This entails a rigorous process that determines whether or not the venture capital fund or other investors will invest in the company. The process involves asking and answering a series of questions to evaluate the business and legal aspects of the opportunity.

The due diligence process should select potential winners, identify the key risks associated with the investment and develop a risk mitigation plan with the company management as part of a potential investment. Once the process is complete, the investor will use the outcomes of the process to finalise the internal approval process and complete the investment.

Signing the term sheet

A Term Sheet (TS), as the name implies, covers the key terms of the investment. Two of the most important terms in the TS are the valuation of the company (price) and the transaction structure. If the due diligence phase is satisfactory, the VC will offer a term sheet.

This is a non-binding document that spells out 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 the legal documentation can be completed by three to four weeks. After the legal due diligence funds will be made available.

Execution with venture capital Support

Once the term sheet is signed, the venture capitalist becomes actively involved in the company’s activities. Venture capitalists normally do not make their entire investment in a company at once; they do this only in “rounds.”

As the company meets previously agreed milestones, further rounds of financing are made available, with adjustments in price as the company executes its plan.

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