Venture Capital process and pros and cons

What is Venture Capital?

It is a private or institutional investment made into early stage/start-up companies (new ventures). As defined, ventures involve risk (having uncertain outcome) in the expectation of a sizeable gain. Venture Capital is money invested in businesses that are small; or exist only as an initiative but have huge potential to grow. The people who invest this money are called venture capitalists (VCs). The venture capital investment is made when a venture capitalist buys shares of such a company and becomes a financial partner in the business.

Venture Capital investment is also referred to risk capital or patient risk capital, as it includes the risk of losing the money if the venture doesn't succeed and takes medium to long term period for the investments to fructify.

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.

Features of Venture Capital investments

• High Risk
• Lack of Liquidity
• Long-term horizon
• Equity participation and capital gains
• Venture capital investments are made in innovative projects
• Suppliers of venture capital participate in the management of the company

Methods of Venture capital financing

• Equity
• participating debentures
• conditional loan
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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
• Start-up
• Ramp up
• Exit

Step 1: Idea generation and submission of the Business Plan- Seed Stage

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 a 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 completed 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. The first step for any business looking for venture capital is to submit a business plan, either to a venture capital firm, or to an angel investor.

Angel Investors and Venture Capital Firms

For small businesses, or for up-and-coming businesses in emerging industries, venture capital is generally provided by high net worth individuals (HNWIs) – also known as ‘angel investors’ – and venture capital firms.

• Start-up: New firms needing funds for expenses related to marketing and product development
• First-Round: Manufacturing and early sales funding
• Second-Round: Operational capital has given for early stage companies which are selling products, but not returning a profit. trying to minimize their losses in order to reach break even.
• Third-Round: Also known as Mezzanine financing, this is the money for expanding a newly beneficial company
• Fourth-Round: Also called bridge financing, 4th round is proposed for financing the "going public" process
• Mezzanine/bridge/pre-public stage

In general, this is the last stage of the venture capital financing process. The main goal of this stage is for the venture to go public so that investors can exit the venture with a profit commensurate with the risk they have taken.

At this stage, the venture achieves a certain amount of market share. This gives the venturesome opportunities, for example:

• Merger with other companies
• Hostile Takeover
• Keeping new competitors away from the market
• Eliminate competitors

Internally, the venture has to examine where the product's market position and, if possible, reposition it to attract new Market segmentation. This is also the phase to introduce the follow-up product/services to attract new clients and markets. Ventures have occasionally made a very successful initial market impact and been able to move from the third stage directly to the exit stage. In these cases, however, it is unlikely that they will achieve the benchmarks set by the VC firm.

A) Early Stage Financing:

Early stage financing has three subdivisions 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 in expanding 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.

Exit route

There are various exit options for Venture Capital to cash out their investment:

• IPO
• Promoter buyback
• Mergers and Acquisitions
• Sale to another strategic investor

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
• Venture capital is an important and necessary form of investment because it fosters entrepreneurship, especially in high-tech and other innovative industries. This, in turn, promotes job creation and economic growth. At the investment level, venture capital can be tremendously lucrative because it allows investors to get in at the ground level of what could be some of tomorrow's leading companies.
   

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

Examples of venture capital funding

• Kohlberg Kravis & Roberts (KKR), one of the top-tier alternative investment asset managers in the world, has entered into a definitive agreement to invest USD150 million (Rs 962crore) in Mumbai-based listed polyester maker JBF Industries Ltd. The firm will acquire 20% stake in JBF Industries and will also invest in zero-coupon compulsorily convertible preference shares with 14.5% voting rights in its Singapore-based wholly owned subsidiary JBF Global Pte Ltd. The funding provided by KKR will help JBF complete the ongoing projects.

• Pepperfry.com, India’s largest furniture e-marketplace, has raised USD100 million in a fresh round of funding led by Goldman Sachs and Zodius Technology Fund. Pepperfry will use the funds to expand its footprint in Tier III and Tier IV cities by adding to its growing fleet of delivery vehicles. It will also open new distribution centers and expand its carpenter and assembly service network. This is the largest quantum of investment raised by a sector focused e-commerce player in India.

Conclusion:

Considering the high risk involved in the venture capital investments complimenting the high returns expected, one should do a thorough study of the project being considered, weighing the risk-return ratio expected. One needs to do the homework both on the Venture Capital being targeted and on the business requirements.