What is Venture Capital

What Is Venture Capital

Editor: TANEO S.A., New Economy Development Fund S.A.

Venture capital is the term used when investors buy part of a company. A venture capitalist places money in a company that is high risk and has the possibility of high growth. The investment is usually for a period of five to seven years, after which, the investor will expect a return on his money either by the sale of the company or by offering to sell shares in the company to the public. There are three different types of venture capital investment: early stage, expansion, and acquisition financing. When investing venture capital, the investor may want receive a percentage of the company’s equity and may also wish to have a position on the director’s board. An investor who agrees to place capital in a company is looking to make a healthy return, so he can demand repayment by the sale of the company, asking for his funds back or renegotiating the original deal.

Stages of Financing

These are the typical funding stages that a startup moves through over the course of its life. Post IPO (i.e., Initial Public Offering) financings are not covered here as the focus is on the privately-held phase of the company's life.

Seed or Concept stage financing

The venture is still in the idea formation stage and its product or service is not fully developed. The usually lone founder/inventor is given a small amount of capital to come up with a working prototype. Monies may also be spent on marketing research, patent application, incorporation, and legal structuring for investors. It's rare for a venture capital firm to fund this stage. In most cases, the money must come from the founder's own pocket, from the "3 Fs" (Family, Friends, and Fools), and occasionally from angel investors.

Startup financing

The venture at this point has at least one principal working full time. The search is on for the other key management team members and work is being done on testing and finalizing the prototype for production or launch of version 1.0.Early stage venture capitalists--who are as rare as hen's teeth--may fund this stage. But more likely, it will be sophisticated angel investors.

First -stage financing

The venture has finally launched and achieved initial traction.  Sales are trending upwards. .A management team is in place along with employees.  The funding from this stage is used to fuel sales, reach the breakeven point, increase productivity, cut unit costs, as well as build the corporate infrastructure and distribution system. At this point the company is two to three years old.

Second -stage financing

Sales at this point are starting to snowball. The company is also rapidly accumulating accounts receivable and inventory.  Capital from this stage is used for funding expansion in all its forms from meeting increasing marketing expenses to entering new markets to financing rapidly increasing accounts receivable. Venture capital firms specializing in later stage funding enter the picture at this point.

Third stage financing

At this stage the future is so bright and everything looks good. Sales are climbing. Customers are happy.  The second level of managers is in place. Money from this financing is used for increasing plant capacity (or other capacity depending on the nature of the business), marketing, working capital, and product improvement or expansion.

Mezzanine or Bridge financing

At this point the company is a proven winner and investment bankers have agreed to take it public within 6 months. Mezzanine or bridge financing is a short term form of financing used to prepare a company for its IPO.  This includes cleaning up the balance sheet to remove debt  that may have accumulated, buy out early investors and founders deemed not strong enough to run a public company,  and pay for various other costs stemming from going public. The funding may come from a venture capital firm or bridge financing specialist. They are usually paid back from the proceeds of the IPO.

Initial Public Offering (IPO)

The company finally achieves liquidity by being allowed to have its stock bought and sold by the public. Founders sell off stock and often go back to square one with another startup. Please note that some companies have more financing stages than shown above and others may have fewer. Very few reach the bridge and IPO stages. It all depends on the individual company. Before approaching a venture capital firm you need to first confirm that it invest in the financing stage your company needs.

What to expect from a VC firm

First and foremost, the venture capitalist wants to see a firm that can become highly profitable and dominate the market, meaning that within 4 to 7 years it can go public or merge with a high price/ earnings multiple. It is the people who will do that, hence demonstration of a solid management team with a dynamic leader is also very important. Then, the VC firm will focus on the product or service presented before them. It is a no brainer that a good or service that provides high value is sought. It would be very appealing if this product was in an environment (market) that was growing steadily and at a high pace, and with limited completion to block its development, as well as the ability to achieve positive cash flow and break even sales. These are again only some of the aspects that venture capital firms are looking for. There are a lot more information that you should take care of in order to create a positive image.

Basic Info regarding the investment process

In Brief we could summarize the lifecycle of an investment as a process that lasts approximately from 3 to 5 years. It begins with the business plan receipt from the potential investee, with all supporting documentation. It is very important to note that the quality if the Business Plan is key for the success of a venture. A thoroughly prepared business plan with a clear view on all the objectives involved might be the difference between rejection and approval to the screening stage. The VC fund then, performs an initial evaluation of the plan and arranges a meeting with the company management. It is very important to note that despite the common belief that VC firms are risk takers, they are actually risk averse. During this stage of the process, the people that present their idea are of equal, if not more, importance as the idea itself. Experience shows that VCs invest mainly in the people. Following the initial evaluation and assuming that interest is still high, a letter of intent is drafted which mainly provides safeguards for both parties as well as indicates that the two parties are currently under negotiations. After the LOI is drafted, the fund will perform the due diligence process, which involves technical, business and financial analysis of all the data included in the business plan in order to get a clearer view of the pros and cons of the potential investment in question. If all of the aforementioned goes according to plan, the fund performs a valuation of the company based on the investment period in question and finally it will submit an investment proposal to the investment committee which in turn takes a decision. Assuming that the decision is positive the investment is concluded. In order to give examples on the costs of investment involved it might be beneficial to mention TANEO’s strategy. TANEO has am investment cap of €5m with a restriction of €2,5m per year. Roughly the decision takes 1 to 3 months.

The second part of the investment’s lifecycle involves its monitoring and support. The main goal from the VC’s point of view is for the investment to blossom and in order to achieve that, the fund aims in adding value through enhancing its sale channel, financial consultation, partnerships, process optimization, cost reduction and strategic support. We should point that apart from the financial support, the consultation services that a VC fund is able to provide to the investee company is of equal importance in order to achieve growth and profitability. Once the company grows, and profits soar, the VC funds will start to seek, along with management team of the investee company, potential exit strategies from its investment in order to capitalize from it. Potential exit opportunities will include an initial public offering (IPO) a trade sale, management buy back or the sale to another VC or PE firm. This process following investment to exit from the company usually takes from 3 – 5 years.

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