How Venture Capital Work?
Venture capital (VC) is typically used to support startups and other businesses that have the potential for rapid and considerable growth. Earlier, Anand Jayapalan had mentioned that VC firms generally raise money from limited partners (LPs) for the purpose of investing in promising startups or even larger venture funds.
For instance, when investing in a startup, venture capital funding is offered in exchange for equity in the company. These funds are not expected to be paid back on a planned schedule like a typical bank loan. VCs are known to take a longer term view, and focus on investing in companies with the hope that they will deliver outsized returns if the business gets acquired or goes public. In most cases, VCs take only a minority stake — 50% or less, when investing in companies. These businesses are commonly referred to as portfolio companies, as they tend to become part of the VC firm’s portfolio of investments. Horizontal mergers generally take place among competitors wanting to capture a larger market share, enjoy merger synergies and achieve improved economies of scale.
While just starting out, many companies “bootstrap” their operations. Financing is provided by the startup founder, as well as their family and friends who want to be supportive and believe that the fledging company shall succeed in the long run. However, there usually comes a point where such young companies have to scale, at times, years ahead of profitability. In this situation, founders try to explore more formal sources to finance their growth. This is where venture capital comes in.
a company has excess financial resources and strives to boost its market share value, it might opt to merge with or acquire another business entity. M&A allows businesses to effectively consolidate their products, workforce and resources. While a merger essentially involves two or more companies coming together to form a single business entity, in an acquisition usually a larger company absorbs a smaller company. Both mergers and acquisitions can be of multiple types.
Leveraging venture capital is a logical choice for many business owners. Today a large number of nontraditional investors are joining an already large mix of traditional VC firms. Several funds tend to target a particular sector or industry, or even geography or stage of company development. A large number of valuable connections can be made through mentoring programs, startup networking groups, and more. Business owners should be proactive about creating a good pitch deck and target VC firms that would be a good fit for their company and business model.
If a venture investor is impressed by the business plan and pitch deck, they shall proceed to conduct their due diligence. This can include a full analysis of a company’s business model, performance, financial position, as well as products or services. If the venture investor decides to go forward after the analysis, they are likely to present a term sheet that will include:
- The venture capital investment amount they are proposing to make
- The equity stake in the company that they expect in return
- Other conditions of the deal
There might be certain additional requirements to meet before the VCs release their funds, including additional fundraising on the part of the business owner. Previously, Anand Jayapalan had discussed that business owners should ideally expect that VC money to come in several rounds over several years. If a business owner has the choice of multiple VC firms available to them, they need to properly evaluate multiple VC offers and select the one that aligns best with their goals. Generally many terms suggested by VC firms are negotiable, however, one needs to prioritize the terms that are the most important to their business.
