The various stages at which the venture capitalist provides finance.
WHAT IS VENTURE CAPITAL?
Venture capital is defined as a form of private equity financing that provides funds to early-stage, emerging companies which has the potential for significant growth and financial returns. This is usually provided in the form of equity apart from conditional loans and conventional loans. It is an investment vehicle for high net worth individuals and institutional investors. Wealthy investors like to invest their capital in startups with a long-term growth perspective. This capital is called venture capital and the investors are called venture capitalists, in other words, it is a way for companies to receive money in the short term and for investors to grow wealth in the long term.
The fundamental need for funding in start-up firms comes from the entrepreneur’s wealth constraints. One important characteristic of many start-ups is the high risk due to the earlier stage of the business, greater uncertainty about returns, the lack of substantial tangible assets and the lack of a track record in operations. Many start-ups may face many years of negative earnings before they start to see profits. Given this situation, banks and other intermediaries are averse to or even prohibited from lending money to such firms. Moreover, these financial intermediaries usually lack expertise in investing in young and high-risk companies. Consequently, these start-ups often seek venture capitalists to be involved in their activities by offering revenue sharing in the form of equity joint ventures in order to obtain the necessary funding and to benefit from the venture capitalists ‘experience in management and finance.
STAGES OF VENTURE CAPITAL FUNDING
A venture capital fund provides finance to the venture capital undertaking at different stages of its life cycle according to requirements. These stages are broadly classified into three main stages, viz.
(1) Early-stage financing,
(2) Expansion Stage
(3) Later-stage/ Acquisition/ Buyout Financing
Let’s discuss them separately.
(1) Early-stage Financing
Early-stage financing is divided into three sub-stages:
(i) Seed Capital
This is the primary stage associated with research and development. The concept, idea, and process pertaining to high technology or innovation are tested on a laboratory scale. Generally, the ideas developed by the Research and Development wings of companies or scientific research institutions are tried. Based on a laboratory trial, a prototype product development is carried out. Subsequently, possibilities of commercial production of the product are explored.
Seed capital is initial funding typically sought by entrepreneurs who are just starting out and don’t have a product of organized business yet. Seed capital is the funding required to get a new business started. There aren’t many venture capitalists willing to fund at this stage since they aren’t very inclined to invest large amounts of money in an idea that still exists only on paper. This initial funding, which usually comes from the business owner(s) and perhaps friends and family, supports preliminary activities such as creating a sample product, market research, product research and development (R&D), covering the administrative costs and business plan development.
(ii) Startup Stage
Venture capital finance is made available at the start-up stage of the projects which have been selected for commercial production. A start-up refers to launching or beginning a new activity which may be the one taken out from the Research and Development stage of a company or a laboratory or may be based on a transfer of technology from abroad. Such a product may be an import substitute or a new product/service which is yet to be tried. But the product must have effective demand and command the potential market in the country. The entrepreneurs who lack financial resources for undertaking production, approach the venture capital funds for extending funds through equity.
Startup stage funding is given to a startup so it can launch its business, e.g. recruit initial staff, acquire office space and permits, further market research and testing, and finish the development of its product or service. Companies seeking this type of funding already have a sample product available and at least one executive working full-time. Funding at this stage is also rare. It tends to cover the recruitment of other key management, additional market research, and finalizing of the product or service for introduction to the marketplace.
(iii) Early Stage/ First Stage Capital
Early-stage/ First stage Capital is intended for businesses that have gotten off the ground and have been operating for two to three years, have a management team in place, and their sales are growing. At this point, they are moving toward profitability as they push their products, services, and even advertising to a wider target audience. After the product has been launched in the market, further funds are needed because the business has not yet become profitable and hence new investors are difficult to attract. Venture capital funds provide finance at such a stage, which is comparatively less risky than the first two stages. At this stage, finance is provided in the form of debt also, on which they earn a regular income.
Since such startups have spent all their starting capital by now, they need further financing to intensify business activities, enhance productivity and marketing, and/or increase efficiency.
(2) EXPANSION STAGE FINANCING
Even when the business of the entrepreneur is established it requires additional finance, which cannot be secured by offering shares by way of the public issue. Venture capital funds prefer later stage financing as they anticipate income at a shorter duration and capital gains subsequently.
Expansion financing is divided into three subcategories:
(i) Expansion Stage/ Second Stage Financing
(ii) Bridge Financing
(iii) Third Stage Financing
(i) Second Stage/Expansion Finance
Expansion finance may be needed by an enterprise for adding production capacity once it has successfully gained market share and expects growth in demand for its product. Expansion of an enterprise may take the form of organic growth or by way of acquisition or takeover. In the case of organic growth, the entrepreneur retains maximum equity holdings the entrepreneur and the venture capitalist could be in much higher proportion depending upon factors such as the net worth of the acquired business, its purchase price and the amount already raised by the company from the venture capitalists. Such capital is provided to well-established firms with a multi-functional team and commercialized products and a good sales momentum under their belt. The purpose is to add the fuel necessary to take the business to the next level.
(ii) Bridge financing/ Bridge Financing
It refers to financing in between full VC rounds with the objective to raise smaller sums of money instead of a full round. Existing investors are usually the ones participating in this type of funding. There are VCs that focus on this end of the business spectrum, specializing in initial public offerings (IPOs), buyouts, or recapitalizations. If you are planning an IPO, a VC may also assist with mezzanine or bridge financing – short-term financing that allows you to pay for the costs associated with going public.
(iii) Third/late-stage financing
Such financing happens when a startup has reached massive revenue, has a second level of management, and is now seeking funds to grow capacity and working capital, and/or build-up marketing efforts even more. Late-stage financing has become popular due to the fact that venture capitalists prefer to invest in ventures with lower failure risk (as opposed to the early-stage companies).
When a company is operating at a loss after crossing the early stage and entering into commercial production, it may plan to bring about a change in its operations by modernising or expanding its operations, adding to its existing products or deletion of the loss-making products, by reorganising its staff or undertaking aggressive marketing of its products, etc. For undertaking the above steps for reviving the company, an infusion of additional capital is needed. The funds provided by the venture capitalist for this purpose are called turnaround financing. In most cases, the venture capitalist who supported the project at an early stage may provide turnaround finance, as a new venture capitalist may not be interested to invest his funds at this stage.
(3) ACQUISITION & BUYOUT CAPITAL
The last of the venture capital funding types are divided into:
(I) Replacement Finance
(ii) Acquisition Financing
(iii) Buyout Financing
(i) Replacement Finance
In this form of financing, the venture capitalist purchases the shares from the existing shareholders of the company who are willing to exit from the company. Such a course is often adopted by the investors who want to exit from the investee company, and the promoters do not intend to list their shares in the secondary market, the venture capitalist perceives growth of the company over 3 to 5 years and expects to earn capital gain at a much shorter duration.
(ii) Acquisition Financing
Acquisition capital is the provision of the immediate resources used specifically to assist a company in acquiring certain parts of another business or the entire business for itself. Through such a purchase, the smaller company can grow the size of its operations and benefit from the larger scale economies.
(iii) Buyout Deals
A venture capitalist may also provide finance for buyout deals. Management (MBO) or Leveraged Buyout (LBO) Financing includes a significant amount of money that helps a particular management group to conduct the management or leveraged buyouts. Management buyouts provide a preferred exit strategy for companies looking to sell off divisions outside of their core business or for private businesses whose owners plan to retire.
Leveraged buyouts use massive borrowed funds, with the assets of the target company (the one being acquired) regularly used as collateral for the loans. The buyout company may also sell parts of the target firm to pay down the debt. This high-risk, high-reward strategy requires the acquisition to realize high returns and cash flows so that the interest on the debt can be paid.
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About the author
Dileep K Nair
Mr Dileep is currently the managing partner of Unifinn Capital Global and an advisor to the investment banking and corporate finance world. He is a mentor, entrepreneur and business advisor with an overall 19 years experience, 12 plus years of banking and finance experience and 7 plus years experience in investment banking and corporate finance, with relevant experience in handling private equity transactions, private debt, venture capital, angel investing, M&A, other growth capital transactions and real estate financing transactions.