What is Venture Capitalist (VC) and How Venture Capital Work?

Do you know why a venture capitalist is important for any business? Have you ever booked a last-minute ride on uber? Or have you ever tweeted your radical opinion on Twitter? Regardless, you must have used google to look up some information. We all enjoy listening to our favourite songs on Spotify. And everyone loves to use WhatsApp to connect to friends, family, and even business connections.

But do you know what all of these businesses have in common?

These companies, Uber, Twitter, Whatsapp, and even Spotify, began as small startups that no bank wanted to loan out money. So how did they become so popular? The reason behind their success is a venture capitalist.

Venture Capitalists invested in these startups. They also provided them with funds to help them in their work. It is their advice that helped turn these startups into industry leaders.

Venture Capital is a buzzing term in the startup world. Everybody is talking about it. They talk about what a miracle it is to have them. They also talk about how venture capitalists provide funds to high-risk entrepreneurs.

All startup owners want it. They want these VCs to help kickstart their businesses. But not all startup owners know what it is exactly. If you are one of them and want to understand venture capital and want venture capitalists to invest in your startup, then keep on reading.

What is a Venture Capitalist (VC)?

A venture capitalist is a person who invests in startups. These are usually those startups that have a high possibility of becoming successful in the future. Venture Capital is usually a tool of big investors, individuals, and banks. Other financial institutes might also give out such funds.

But VC doesn’t need to take the form of money. It can also be in the form of advice. This advice can be technical and control-related. Venture capital can be related to funding firms with great growth potential. It is also given to firms that have previously shown quick growth and show chances of expansion in the future.

Venture capitalists have to face a lot of risks while taking up such investments. This is because not all firms might live up to expectations.

Venture capital is increasingly becoming popular for young startups with limited experience (less than two years). This is because of the lack of access to capital markets, banks, or other debt devices as a source of raising money.

The primary downside of this is that the venture capitalist gets equity, i.e., some shares in the company. This gives them the power to influence major decisions of the company. This can come in the way of the owner of the startup.

Understanding Venture Capitalists

Form

Venture Capitalist firms are mostly in the form of Limited Partnerships (LPs). In such a case, the partners invest in the VC fund. The fund assigns a board with the task of making investment decisions. After identifying firms with favourable prospects, the funds contributed by all the partners are invested in these firms. In return, the VC investors get a stake of equity in these startups.

Funds

It is a myth that VCs provide funds to startups in the initial stage. On the contrary, VCs look for startups ready to take their idea to the next level. Venture capital funds invest in these companies, support their development, and seek to exit with a large return on investment (ROI).

They are on the lookout for those firms that have a solid management team. They also look for a sizable market and a distinctive offering with a significant competitive advantage. Additionally, they search for possibilities in sectors of the economy they are already in. They can then buy a portion of the companies voting rights and steer the industry’s growth.

Risk

Unlike Angel investors, VC firms don’t use their own money. They control the pool of money of other investors. VCs have a high failure risk as there is no surety in the success of a new firm. But they are still willing to face such risk because they can earn huge returns on their investment if these firms succeed.

The VC firm manages a fund that may be pooled together by wealthy individuals, insurance firms, pension funds, foundations, and corporate pension funds.

Decision-Making

The VC firm makes the investment decisions even though all the partners own a portion of the fund. The other businesses are limited partners, while the venture capital firm serves as the general partner.

Management fees and carried interest are paid to the VC fund managers. Depending on the company, 20% or so of the earnings go to the firm taking care of the fund. The remaining proceeds are distributed to the limited partners who invested in the fund. Typically, general partners usually get an additional 2% fee.

History of Venture Capital

The onset of economic freedom in 1986 brought with it venture capitalism. A set of regulations were released in 1988, formalizing venture capitalism in India. VC was initially limited to the subsidiaries established by IDBI, ICICI, and the IFC and focused on major industrial firms.

However, the pivotal moment occurred when established Indian startups in Silicon Valley persuaded VC investors about India’s growth potential. The Indian VC sector has seen an increase in the number of private investors over time, both domestically and internationally.

Initially, venture capital investments were mostly made in the manufacturing sector. But shifting patterns and growing economic liberalization made consumer services and retail sector companies leading competitors for VC funding.

Other noteworthy sectors attracting VC firms were banking, media, and entertainment. Education, software development, telecommunications, electronics, and other services are also in the race.

Agriculture is a brand-new industry that is drawing the attention of venture capitalists. The realization that food security is important and a requirement for all has fueled this. According to studies, for every 100 rupees of an upward moment in GDP, 41 rupees will be spent on food in the future.

A new sanctuary for VCs may probably emerge in agriculture. Leading VC firms have already made their presence felt in this industry. These include Venture Dairy, Anterra Capital, and SAEF (Small Enterprise Assistance Funds).

Positions Within a VC Firm

A venture capital firm’s general layout varies from one firm to another. But typically, it can be categorized by the following three positions:

1. Generally, associates with experience in business consulting or finance and sometimes a business degree join Venture Capitalist firms. They often carry out analytical work. This includes thoroughly studying company models, market trends, and industry sectors. Additionally, they also work with the firm’s portfolio. These associates do not have any power to influence the making of important decisions. But they can introduce the higher-ups to prospective startups.

2. A principal is a mid-level professional who typically sits on the board of portfolio firms. They are responsible for ensuring that the firm runs smoothly and finding the perfect investment options for the company to consider. They also negotiate the terms for both acquisition and exit of the deal.

3. Depending on the returns they can produce from the agreements they close, principals are on a “partner track.” Partners are concerned with selecting specific industries or particular businesses for the firm to engage. They approve transactions—whether they are investments or exits. They represent the company to the world. Partners also occasionally serve on the boards of portfolio companies.

Also read: Top 20 Venture Capitalists in India for NRI Investment

What Is The Difference Between Angel Investors and Venture Capitalists?

High net worth individuals (HNWIs) are called “angel investors.” Angel investors and venture capital firms typically give funds to small firms or up-and-coming companies in new industries.

Angel investors often consist of a wide range of people who have earned their riches from various means. They often are business owners themselves or executives who have recently left the corporate empires they founded.

Self-made investors who provide venture money have some essential traits in common. Most angel investors prefer to invest in well-run firms with solid business plans and room for significant expansion.

Additionally, these investors may offer to support projects associated with industries or business sectors they are already familiar with. They may have had academic instruction in that field even if they haven’t worked there.

Co-investing is another frequent occurrence among angel investors. In co-investing, one angel investor finances a project with a reliable friend or associate—often another angel investor.

Dependency

An angel investor works independently, whereas a venture capitalist is an employee of a business or firm.

Services

Venture capitalists look for a strong, competitive product or service, a talented management team, and a broad market potential. Angel investors primarily offer financial support.

Experience

Angel investors focus on early-stage businesses and finance late-stage technical growth and early market launch. On the other side, VC firms invest in established firms and startups. The decision depends on the venture capital industry. A venture investor will seek to invest in a startup with a lot of growth potential and great promise.

Trust

Angel investors have faced a lot of controversy regarding due diligence. Many angels work very little. Since they own all the funds, they are not required to do so. Since investors still have a trust-based relationship with their restricted partners, they must exercise greater due diligence.

Authority

VCs are more likely to destroy your firm. The fact that VCs sit on the board of directors for your company strengthens their capacity to have an impact on the startup. Angels normally do not and should not.

Also, read the following:

• Angel Investors: What Is Angel Investing & How Does It Work?
• How to Start a Startup in India – A Complete Guide

How does venture capital work?

1. To get venture funding, the first step for a startup would be to prepare and submit a business plan to a VC investor. If interested in the submission, the firm will perform due diligence. This means they will thoroughly study the company’s business model, products and services, management, experience, history, and other related factors.
2. VC firms invest a huge amount of money in a small number of firms. So to make sure that they invest in the right fund, they do a thorough background check. VC firms try to focus their attention on a specific industry. Once this step is completed and satisfied the firey will offer a specific amount of funds in return for a stake in the firm’s equity.
3. These funds then can be given in lump sums or instalments. The firm actively participates in the work of the funded company. They provide advice and observe its development before providing them with new funds.
4. After some time has passed, usually four to six years after the initial investment, the investor quits the firm. This is done through a merger, acquisition, or initial public offering (IPO).
5. This arrangement benefits both parties. The startup gets the funding required to grow, and the VC firm can make gains through a successful startup story.

Firms go through many stages of venture capital as they develop. Additionally, businesses or investors could concentrate on a single stage, affecting their investment.

Seed-stage

A seed round is when a venture capitalist invests a small amount of money in a firm for business plan creation, market research, or product development. As its name implies, a seed round is frequently the company’s first formal round of institutional capital. In return for their investments, seed round investors frequently receive convertible notes, equity, or preferred stock options. Nosso, a finance firm based in Cambridge, England, raised $2.7 million in initial money in February 2022.

Early-stage

Companies in the development stage are the target audience for venture capital funding in the early stages. Because new firms require more funds to launch operations once they have a viable product or service. This financing level typically has a higher funding amount than the seed stage. The rounds or series in which venture capital al invested get identified by letters: Series A, Series B, Series C, and so on. San Francisco-based Planet FWD, established in 2019, received $9.96 million in early-stage Series A venture capital funding in May 2022.

Late-stage

The late stage of venture capital funding is for more established firms with shown revenue generation and growth, whether or not they are profitable. Each round or series has a letter assigned to it, similar to the early stage. Although late-stage investment rounds can run up to a Series K, Series D, Series E, and Series F are more typical.

A venture capital firm makes money and distributes returns to the limited partners who invested in its fund if a company it has invested in is bought or goes public. Selling some of its shares to another investor in what is referred to as the secondary market. This would also be profitable for the company.

What is Corporate Venture Capital?

There is a segment of venture capital known as corporate venture capital (CVC). A corporate venture capital firm makes investments on behalf of big firms that strategically fund startups. Funds are invested in firms in or near their core industry to acquire a competitive edge or boost profits.

In contrast to VC investments, CVC investments are made with corporate funds rather than capital from limited partners.

CVC was established due to the rapid growth of startup firms in the technology sector. CVC’s primary objective is gaining a competitive edge and access to new, innovative businesses that could one day compete for business.

In contrast to pure venture capital investments, CVC doesn’t work with outside investment firms and doesn’t own the startup companies it invests in.

Some of the biggest participants in corporate venture capital are:

• Ventures Google
• Snapdragon Ventures
• Salesforce
• Smart Capital

CVCs are also common in other sectors, including biotechnology and telecommunications firms. CVC has a rapidly expanding market presence thanks to its 1,100 seasoned funds and over 475 new funds.

Objectives

Corporate Venture Capital pursues strategic and financial objectives, in contrast to Venture Capital. Monetarily driven CVCs invest in new companies for leverage. They do so to increase the sales and profits of the venturing company. This is done through deals with startups that use new technologies, expand into new markets, identify beneficial targets, and access new resources.

This is frequently accomplished through investment exits, such as initial public offerings or selling the VC firm’s stakes to interested parties. Both strategic and financial goals are frequently combined with increasing investors’ returns.

How do Venture Capital Firms make Money?

Management fees and carrying costs (carried interest) are the main ways venture capital firms generate revenue. These are explained below.

Management Costs

Management costs are generally considered the price of hiring professionals to manage your assets. What does this mean for the venture capital sector? VC funds commonly pay an annual management fee to the fund management company as compensation and to cover administrative and fund costs. Typically, management fees are established as a proportion of the fund’s capital commitments, or around 2 to 2.5 per cent.

Carried Interest

Interest or carry is the portion of the investment’s returns paid to management over the manager’s contribution to the partnership. In layman’s words, a carry is the portion of gains paid to the fund manager when an investment is successful. 20% to 25% of profits are often carried interest in venture capital, which means that although 20% of profits go to the general partners, 80% belong to the limited partners.

Entrepreneur Exit Techniques

An “exit” is the procedure that enables venture capitalists to realize their rewards. Investors in venture capital might depart at various times and use various exit strategies. A wise choice about how and when to leave also greatly impacts the investment’s return.

1. Secondary market

Before the firm goes public, venture capitalists can sell their shares to other interested investors. Trades take place in private equity space as equity is not offered in open markets.

2. Share Repurchase

Investors can take up many roles. They can be purchasers, private equity investors or other VC firms. A buyback of shares can happen, where previous owners can also buy back their shares.

3. Initial Public Offering (IPO)

If the business is doing well and moving to the public exchange, the venture capitalists can pick the IPO approach by selling their shares in the open market after the IPO. There is often a lock-up period following the initial offering, during which insiders, including venture capitalists, are not permitted to sell their shares. It is done to prevent the stock price from dropping due to an influx of lots of shares into the market. The length of the lock-up term is defined in the contract.

4. Liquidation

Liquidation is one inescapable exit plan for venture capitalists. This is especially bad for venture investors since it happens when a company fails and must disperse its assets to pay its claimants. The liquidation preference, which sets the order in which claims may be rewarded, is specified in the contract. This is one of the fundamental ideas that venture capitalists need to comprehend.

What’s the Difference Between Venture Capital and Private Equity?

Both venture capitalists and private equity investors participate in the private equity market by investing in and selling their shares of firms. There are still big differences between the two categories of investors.

1. Types of Investee Companies

The types of investee companies are one of the key distinctions. Private equity investors frequently purchase mature firms whose value may decline due to ineffective management. Private equity investors can take over publicly traded companies and turn them private. Therefore the investee companies are not just restricted to private ones.

On the other hand, venture capitalists focus on early-stage firms with significant growth potential. These startups use cutting-edge technology but need capital funding. All of the firms are tiny, privately held firms.

2. The Percentage of Ownership

Another notable distinction is that leveraged buyouts (LBOs), in which private equity investors typically acquire 100% ownership of the target firms, are used to finance the acquisition costs. Nevertheless, venture capitalists typically only acquire up to 50% of the invested business through equity. It enables them to spread out the risks by diversifying their investments.

Summary

An essential phase of a new firm’s lifetime is represented by venture capital. A firm needs enough startup funds to recruit staff, rent space, and develop a product before it can start making money. VCs provide this money in return for a portion of the equity in the startup company.

Startup firms can benefit from the VC firm’s vast domain knowledge, well-known brand, sound financial position, a network of contacts, and ecosystem of developed products.

VCs provide a doorway for purchasing smaller, cutting-edge firms for investing companies. Even though smaller startups are stealing the show and surpassing the trailblazing giants, VCs can still keep their position as market leaders thanks to their strategically and financially driven ambitions.

Frequently Asked Questions

Here are some useful resources:

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• Essential Guide To Building An Emergency Fund