Venture capital (VC) is a form of private equity funding that is generally provided to start-ups and companies at the nascent stage. VC is often offered to firms that show significant growth potential and revenue creation, thus generating potential high returns.
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How Does Venture Capital Work?
Entities offering VC invest in a company until it attains a significant position and then exits the same. In an ideal scenario, investors infuse capital in a company for 2 years and earn returns on it for the next 5 years. Expected returns can be as high as 10x of the invested capital.
Financial venture capital can be offered by –
- Venture capital firms,
- Investment banks and other financial institutions,
- High net worth individuals (Angel investors), etc.
Venture capital firms create venture capital funds – a pool of money collected from other investors, companies, or funds. These firms also invest from their own funds to show commitment to their clients.
Types of Venture Capital
VC can be categorised as per the stage in which it is being invested. Generally, it is of the following 6 types –
|1||Seed funding||As the same suggests, seed funding or seed capital is the capital invested to help entrepreneur(s) conduct initial activities for setting up a company. This can include product research & development, market research, business, business plan creation, etc.|
Seed funding may also be provided by the owners themselves or their family members and friends.
|2||Start-up capital||Start-up capital is often used interchangeably with seed funding. However, there are minor differences.|
Usually, business owners avail start-up capital after they have completed the processes that involve seed funding. It can be used to create a product prototype, hire crucial management personnel, etc.
|3||First stage, first round or series A||First stage is provided to businesses that have a product and want to start commercial manufacturing, sales, and marketing.|
|4||Expansion funding||As the name suggests, expansion capital is the fund required by a company to expand its operations. The funds can be used to tap new markets, create new products, invest in new equipment and technology, or even acquire a new company.|
|5||Late-stage funding||Late-stage funding is offered to businesses that have achieved success in commercial manufacturing and sales. Companies in this stage may have tremendous growth in revenue but not show any profit.|
|6||Bridge funding||Also known as mezzanine financing, bridge funding helps a company to meet its short-term expenses necessary to create an initial public offering (IPO).|
Features of Venture Capital
Some of the features of venture capital are –
- Not for large-scale industries – VC is particularly offered to small and medium-sized businesses.
- Invests in high risk/high return businesses – Companies that are eligible for VC are usually those that offer high return but also present a high risk.
- Offered to commercialise ideas – Those opting for VC usually seek investment to commercialise their idea of a product or a service.
- Disinvestment to increase capital – Venture capital firms or other investors may disinvest in a company after it shows promising turnover. The disinvestment may be undertaken to infuse more capital, not to generate profits.
- Long-term investment – VC is a long-term investment, where the returns can be realised after 5 to 10 years.
Advantages and Disadvantages of VC
- Help gain business expertise
One of the primary advantages of venture capital is that it helps new entrepreneurs gather business expertise. Those supplying VC have significant experience to help the owners in decision making, especially human resource and financial management.
- Business owners do not have to repay
Entrepreneurs or business owners are not obligated to repay the invested sum. Even if the company fails, it will not be liable for repayment.
- Helps in making valuable connections
Owing to their expertise and network, VC providers can help build connections for the business owners. This can be of immense help in terms of marketing and promotion.
- Helps to raise additional capital
VC investors seek to infuse more capital into a company for increasing its valuation. To do that, they can bring in other investors at later stages. In some cases, the additional rounds of funding in the future are reserved by the investing entity itself.
- Aids in upgrading technology
VC can supply the necessary funding for small businesses to upgrade or integrate new technology, which can assist them to remain competitive.
- Reduction of ownership stake
The primary disadvantage of VC is that entrepreneurs give up an ownership stake in their business. Many a time, it may so happen that a company requires additional funding that is higher than the initial estimates. In such situations, the owners may end up losing their majority stake in the company, and with that, the power to make decisions.
- Give rise to a conflict of interest
Investors not only hold a controlling stake in a start-up but also a chair among the board members. As a result, conflict of interest may arise between the owners and investors, which can hinder decision making.
- Receiving approval can be time-consuming
VC investors will have to conduct due diligence and assess the feasibility of a start-up before going ahead with the investment. This process can be time-consuming as it requires excessive market analysis and financial forecasting, which can delay the funding.
- Availing VC can be challenging
Approaching a venture capital firm or investor can be challenging for those who have no network.
In 2019, the total value of venture capital deployed throughout India was worth $10 billion. This is an increase of 55% compared to the previous year and is currently the highest.
VC was introduced in the country back in 1988, after economic liberalisation. IFC, ICICI, and IDBI were the few organisations that established venture capital funds and targeted large corporations. The formalisation of the Indian VC market started only after 1993.