What is venture capital and how does it work?
The last two years have been highly eventful in the startup world. We saw tons of new brands mushrooming across the country. One of the major factors that enabled this was the generous venture capital funding towards the growing businesses. The Indian startup market today has far better chances of getting funded than it did a decade ago. In fact, 2021 saw Indian startups raising a whopping $42Bn. With multiple modes and sources of funding, choosing the right option can be tricky. If you’re on the same boat, this blog post can help. In this blog post, we tell you everything you need to know about venture capital and how it works so you can make an informed decision.
What is venture capital?
Venture capital or VC funding is a type of financing that involves investing capital in startups or businesses with a minimal operating history but a high potential for growth in exchange for equity. It can be provided at different stages of their evolution, right from seed funding through Series F. A prime characteristic of venture capital financing is that the investment isn’t limited to just the capital but is extended to strategizing and mentoring for the young, often tech-focused startups. VC Funds typically come from institutional investors and high net worth individuals and are pooled together by specialized investment firms. This pooled capital is called a venture capital fund.
Venture capitalists are the ones who actively seek out investment opportunities for the firm as well as help raise capital for venture funds. Generally, venture capitalists, also known as investment capitalists, are more focused on the growth of an industry than of an individual entrepreneur. That is, they look out for brands that are mushrooming in certain industries to invest in. They are usually on the board of these startups and have a say in their operational & strategic decisions.
Venture capitalists can be divided into three types: Domain experts, operators, and networkers. Domain experts are the ones who have years of experience in your domain and know the ins and outs of building a business in the said domain. Operators are the ones with a proven record of growing and scaling businesses in the industry. Networkers are the ones who have a wide network of allies and can help connect entrepreneurs with domain experts and operators.
Typically, venture capitalists expect a yearly return of 25% to 35% over the lifetime of the investment. The idea is to invest for 8-10 years or until the company and its returns reach a sufficient size that is beneficial for the investors of the venture capital firm and to sell it off or take the company public. Read along to see what strategies venture capitalists employ to exit a business.
Venture capital funds are regulated by the Securities and Exchange Board of India (AIF) Regulations, 2012 (Alternative Investment Funds Regulations). These regulations apply to all pooled investment funds registered in India which received capital from Indian or foreign investors.
Some well-known venture capital firms in India are:
Types of venture capital funding
Venture capital funding occurs across various stages of a business. The three primary types of venture capital funding are early-stage financing, expansion financing, and acquisition/buyout financing.
Typically this venture capital financing is done for brands in the seed funding, startup funding, and first-stage funding level. The seed funding stage is typically the stage where the business is just an idea. The startup stage is the one where the funding is given for developing and completing the prototype just before the brand is ready to launch. The first stage of funding is when the company is finally about to start seeing a profit and needs funds for the further development of products. You can know more about how seed funding works in our this blog.
This is the type of financing that is provided by venture capitalists for brands to expand their operations significantly. This usually occurs when the business sees exponential growth and needs additional funds to keep up with the growing demand. Expansion financing is classified into three types: first-stage financing, bridge financing, and second-stage financing. Where first and second stage funding is for further business expansion, bridge financing works as interim financing before the startup raises another round or files for IPO.
Acquisition financing, as the name suggests, is the type of financing where the venture funding is invested into companies acquiring a part or a whole of another business. It is also commonly known as buyout financing.
How venture capitalists are different from angel investors?
Now that you know the different types of venture capital funding, let us walk you through how venture capital works. But before that, if you’re wondering how venture capitalists are different from angel investors and other private equity investors, the below table will help.
We also have a detailed blog explaining difference between venture capital and angel investors that you can read.
It must be noted that since venture capitalists assume absolute risk, their role is not limited to just funding and sharing tips and tricks. They are treated just like an active partner with total investment in the project they invest in.
Bonus: We have established that the VC funds are huge risk-takers. However, what pushes them to take the risk? The management team, business concept and plan, market opportunity, and risk judgement are some of the major factors that help them decide if a business is worth investing in or not. Some questions they would be asking themselves would be if there are any chances for legal issues to pop up, does the product look scalable, would the exit be easy, and so on.
How does venture capital funding work?
In essence, venture capital funding works just like any other type of funding: You have a plan, you meet the venture capital investors, they strike a deal and bam! You have the capital to work on your business. However, it is vital to understand the intricacies of how any type of funding works. To understand how venture capital funding works, you need to know who are the main players involved in the process.
Essentially, there are four main players in VC funding. These are entrepreneurs, investors, investment bankers, and venture capitalists.
The entrepreneurs are the ones who are looking for funding for their businesses. The investors are the folks who are looking for investment opportunities that would yield them high returns. Investment bankers are the individuals who help raise money by selling the company. And the venture capitalists are the ones who capitalize by creating a market for these players.
Structure of a venture capital fund
- The partnership is a combination of limited and general partners. A general partner is an owner of the partnership, and a limited partner is a silent partner in the business.
- The life of the fund ranges from 7 years to 10 years. This means it could start from the seed round and go on through Series A to E and then the final exit.
- The venture capital investments take place over the course of the first two to three years and the returns are usually obtained over the last 2 or 3 years.
So how does venture capital funding work? Read along.
Venture capital firms pool money from wealthy investors, usually large institutions like financial firms, pension funds, insurance companies and high net worth individuals to form venture funds. The VC firm then identifies high-risk, high-return startups to finance and add to their portfolios in exchange for an equity stake. The investors and the venture capital funds make profit as the startups flourish and undergo liquidity events in future such as M&A (merger and acquisition) and filing an IPO. Typically, the portfolios of VC firms are made up of different industries in varying proportions to ensure high returns (and also to make sure any failures wouldn’t have adverse effects).
Let us take an example to understand how venture capital funding works.
You are the founder of a business looking for a venture capital firm to fund your upcoming product . This involves getting capital for manufacturing, marketing, sales, etc.
As a first step, you decide to look for VC firms in your vertical. Websites like CrunchBase offer data and insights into investing firms across sectors.
Once you have a curated list, the next step is to identify whom to reach out to get you acquainted with the partner at the venture capital firm. This contact could be anyone from your network. The point to be noted is to reach out to someone who is credible and also has contacts across the domain. Brownie points if that person is another entrepreneur who is/was funded by the venture capital firm you are targeting.
Bonus: Ideally, a venture capital firm will have people in various roles. Some of the prominent roles are business analysts, associates, and partners.
Once you get in touch with the partner from the venture capital firm, you have mere minutes to pique their interest in your business. If you manage to get their attention, then begins the actual journey of venture capital funding, which is explained below.
What are the stages of a venture capital financing?
The entire deal can be broken down into six steps.
- Business plan: In the first step, you will have to present a business plan to your potential investors. Before you do this, make sure you research the firm and ensure they align with your industry and domain. You should also use this stage to gauge your potential partners and decide if you are willing to get into a partnership with them. Remember, the investors in this stage can either request more information, call for another meeting, or entirely decline your proposal. Here is a detailed article on how to write a great business plan for your startup with free template that you can instantly use.
- Initial negotiation: If the investors are in favor of your proposal, you will then receive an investment memorandum from the fund managers. This would outline the pros and cons of the opportunity and other details, which are usually highly confidential.
- Business valuation: This is one of the most important steps of the process. This is the part where the investors ascertain the potential value of your firm. However, you can also take this time to understand if the fund is really going to add value to your business. Don’t forget to look at alternative sources of funding and compare the risks, pros, and cons.
- Offer letter: Once a valuation is agreed upon, the venture capital firm will then present you with an offer letter. This document will outline all terms and conditions of the venture capital investment along with details about how much they are willing to invest in your business.
- Due diligence: After sending the offer letter, hours and days are spent on due diligence. This is done to ensure the contract is fully in place and there are no errors whatsoever in the proposal or in your business. This is usually done by lawyers and auditors with years of experience in the field.
- Final negotiation: This is the final step where the terms are agreed on and the contract is signed off. Remember, this is also the step where you would be discussing your personal equity stake in the company with the rest of the management. Read our recent blog post on seed funding for tips on negotiating with your investors.
How to choose a venture capital fund?
- When looking for venture capital funding, ensure you approach the firms with specialization in your area of business. Venture capital funds usually target specific industries and businesses owing to their performance rates.
- Be sure your investment criteria match theirs. This would make negotiations easier and the partnership less friction-prone.
- Look at who the investors are. The quality of investors and venture capitalists is essential to your business as it is directly indicative of the mentorship you would be getting throughout the partnership.
- Ascertain how much VC funding you are looking to raise and then look for firms. This is important because venture capital firms tend to have specific funding ranges they are willing to invest in.
Ideally, a venture capitalist looks to exit a business when it has reached its peak. This is essentially the stage where they realize their returns. What are some of the ways in which venture capitalists exit a firm?
Venture capital exit strategies
Before entering a trade, an investor is advised to set a point at which they will sell for a loss and a point at which they will sell for a gain. Venture capitalists can exit a business at different stages of its operation and using different strategies. Some of the most commonly used strategies are as follows:
IPO (Initial Public offering)
An initial public offering or stock launch is a public offering in which shares of a company are sold to institutional investors and usually also to retail investors. It is typically underwritten by one or more investment banks, who also arrange for the shares to be listed on one or more stock exchanges. Investors wait for the most optimal time to conduct an IPO to make sure they earn the best possible return.
Secondary market strategy is the one where the venture capitalist sells their share in a secondary market (where investors purchase securities or assets from other investor) to a third-party, usually other venture capitalists. The highlight here is that the third party would be getting the shares at discounted prices if the venture capitalist is in a hurry to exit or take returns.
This is the strategy where the business decides to buy back the shares of a venture capitalist. While it helps the investor exit a business quickly, it helps the business by increasing the earnings per share.
Acquisition is when you give up your ownership to the company that buys it from you. In this case, the acquiring company makes a tender offer to all shareholders to purchase their shares, often in cash at a premium over what the investors paid.
Entrepreneurship and venture capital: Venture capital myths debunked
Tomes have been written on venture capitalists. While some are true, we have noticed lots of myths that have been passed on for decades. Here are some myths that we feel need debunking.
All venture capitalists are RICH!
This is so untrue. Venture capitalists most often get the capital from venture capital funds. These funds are not unlimited. They have a specific budget that they have to adhere to.
Rejection by a venture capitalist = Your business is bad
While it is easy to get disheartened by rejections, you must also remember that it could be because of the venture capitalist not understanding your pitch. It could also be because your investment criteria do not align. The VC funds typically invest in certain industries (like said in the blog), stages and geography — for investment all these criteria’s need to meet. Don’t be too hard on yourself.
Venture capital is the primary source of startup funding
It is appalling how tons of websites cite venture capital as the primary source of startup funding. Only 0.05% of startup funding comes from VC as per data by Fundable. The Indian startup market today has various sources of funding: Angel investors, bootstrapping, friends and family, crowdfunding, incubators, corporate seed funds, accelerators, debt funding, government schemes, revenue based business loans etc.
Venture capital funding guarantees success
While we all wish this was true, the success of your business mainly depends on your product. While funds from venture capitalists can help you boost your success, no funding can guarantee 100% success if your product and operations aren’t up to the mark.
The sole purpose of a venture capitalist is to help you
We are sorry, but if you believe this, then you are in for a shock. Venture capitalists are in business purely for the profits they get and the joy of being a venture capitalist. While it is true that the performance of your business impacts their profits, more often than not, venture capitalists look forward to a grand exit and are notorious for not being attached to a company beyond professionally.
Does that sound like something you would want to explore? If not, we have a solution for you. If you are looking for a flexible, highly scalable, 100% digital process of raising funds that require no equity dilution, we recommend revenue-based financing. This founder-friendly approach lets founders raise funds without diluting equity, and the repayments happen as a percentage of monthly revenue. You can learn more about revenue-based business loan in our ultimate guide to revenue-based financing.
Being India’s largest revenue-based financier, Velocity provides founder-friendly revenue-based business loans to growing DTC businesses. If you are a D2C brand looking for funding to manage your inventory and marketing needs, apply here, and get funded within 7 days.