What is Venture Capital?
If you are in the early stages of your business, perhaps even in the research phase, and are in need of funding, perhaps venture capital is for you. Let’s look at exactly what it is and if it is appropriate for your business.
Venture Capital (VC) is an investment fund that manages money from investors looking for private equity in start-ups and SMEs with strong growth potential. Investments are typically high risk but with high returns. It is this need for returns that make it an expensive and detailed form of finance.
VC funding is a good option if your businesses still in the concept phase and has a large up-front capital requirement. For example, new IT and technology-based products are the most common cases there the value is unproven. This explains why venture capital funding is most widespread in the fast-growing technology and biotechnology fields.
There are many factors a potential investor will look at, but the very basic ones are:
- The nature and value of the business
- It’s future prospects
- The competition and demand in the market place
VC firms will often have an internal model of what their preferred investment looks like and will actively seek out those opportunities.
Not every business is suited to venture capital and very few businesses who apply for this kind of funding actually get it. It is therefore important that you do your research, choose a fund that matches your requirements and develop a strong business plan.
There are several types of venture capital:
Private venture capital partnerships are perhaps the largest source of risk capital and generally look for businesses with the capability to generate a high return on investment each year. They actively participate in the planning and management of the businesses they finance and have very large capital bases to invest at all stages.
Industrial venture capital pools usually focus on a specific industry and will fund firms that have a high likelihood of success, like high-tech companies or those using state-of-the-art technology in a unique manner.
Investment banking firms traditionally provide expansion capital by selling a company’s stock to public and private equity investors. Some also have formed their own venture capital divisions to provide risk capital for expansion and early-stage financing.
The money is raised in a series of stages or rounds and it is common for a venture capitalist to focus purely on one phase, e.g. early stage. There are typically six stages of VC funding, which roughly correspond to the stages of a company’s development.
- Seed funding: a smaller amount of finance needed to prove a new idea. This kind of funding is often provided by angel investors or through crowd funding
- Start-up: Early stage firms that need funding for expenses associated with marketing and product development. Many VC funds focus on this stage of the business, as they can get in early and reap the rewards of a business that is on an upward spiral
- Growth ( Series A round): Early sales and manufacturing funds
- Second-Round: Working capital for early stage companies that are selling product, but not yet turning a profit
- Expansion: Also called Mezzanine financing, this is expansion money for a newly profitable company
- Exit of venture capitalist: Also called bridge financing, this round is intended to finance the “going public” process
Advantages of VC finance
- Bigger investment: VC finance usually provides a larger amount of money than any traditional bank would
- Value- add: Together with finance, a VC can bring in valuable skills into the business and open your business up to a network of valuable contacts
- Hands off: Most VCs will not want to get involved in the day-to-day running of your business, but will appoint a representative to sit on your board
- Risk: You are now sharing the burden of the financial risk of starting or growing the business
- Credibility: With the backing of a VC, you will find it easier to obtain other streams of funding
- Sustainability: As the business grows, the VC can bring in more rounds of funding
- Business support: It is in their best interest for your business to succeed, so they will get involved if it appears that your business needs help
- The biggest one; VCs take a share of your business, which means you have to be prepared to lose some control of your business
- Venture Capitalists often look for a mixture of debt and equity, so you may have monthly loan repayments over an agreed period
- You have to pay the costs of a due diligence
- The funding is often staggered according pre-determined targets your business must reach
- Sharing more private information about yourself and your business model than you want to
Applying for the funding
A venture capitalist’s appetite will depend on the stage of your business’s development, the industry you operate in and the investment goals of the VC itself.
Make sure you know exactly how much money you are looking for and if you are prepared to lose a corresponding share of your business.
It’s extremely important that you have a solid business plan that sets out everything the investor is looking for, such as the strength of the management team and your passion for the business. In scrutinising the business plan, a VC firm will most likely have three focus areas.
- The product or service: Is this an innovative product or service that gives the company a strong competitive edge? A new idea, backed by market research will catch the eye of these kind of investors
- Management capability: No matter how good the product or how innovative the service, the quality and experience of the management team crucial to the success of the business. A savvy investor looks for solid evidence of such skill
- The industry’s growth: Investors also want to be sure that the product or service is in a growth field. Even the most revolutionary product improvement will not fare well in a declining market
A big factor in the funding process is how much (money or collateral) you are investing into your idea or company. Alarm bells ring when an entrepreneur is not willing to bare some of the risk of funding his business. If you just don’t have the funds to put up and the funder still wants to finance you, it will take a bigger/sometimes majority share in your business to mitigate the risk it is taking by investing in you.
Where can I find these investors?
It’s important that you have a plan for how you will gain access to a venture capital fund, which probably has hundreds of business plans crossing their desks on any given day. So try to get a referral by networking with potential investors.
Attend events offered by your local business chamber and speak to fellow business associates, your banker, attorney and anyone who may have the right contacts. Hopefully the person referring you will have thought about linking up with an investor that is a good fit with your business and its financial needs.
Now that you have done some homework and still believe that VC funding is a good fit for your business, you can make sure your business is ready for investment and most importantly, stands out in the crowd of start-ups seeking venture finance. Make sure your plans are realistic and if you are in any doubt, enlist the help of a business advisor and possibly a lawyer.