Venture capital or “risk capital” is a reliable means of raising funds for new companies that have just started operations, we explain what is it and how does it help startups today.
For many companies even though they can no longer be considered startups, can benefit from this type of financing. This type of investment, although it involves a high level of risk, is considered very attractive for companies seeking to invest their capital in other companies of lesser value, but with great growth prospects.
Considered as a high-risk, high-return business, venture capital is emerging as one of the best investment options for the future. In exchange for a stake or shares in the start-up company, the investor will provide the capital and advice necessary for its better operation and safe growth. Likewise, he will be able to recover his capital plus a substantial return on the sale of his shares, participation, or even the same company that is the object of his investment when its value increases.
What is a Venture Capital (VC)?
Venture capital (VC), also called “risk capital”, is the term used to refer to investment in newly created, high-risk companies. These companies or startups are not listed on the stock exchange because they are very new or considered unsafe. Then, the purpose is to invest when they still lack value to obtain profits on the invested capital, selling the shares or selling the company after it manages to be valued to be listed on the stock exchange.
However, venture capital goes beyond investing in unlisted companies. While investing funds, they also provide technical management support and advice. In this way, they can contribute to a faster and more efficient increase in the value of the target company. And thus, they guarantee and ensure that they protect and further increase their capital and future earnings. This business practice also has advantages and disadvantages for its participants.
Venture capital contemplates two main sources of financing for these investments. The first is the pattern of investment using own funds and the second pattern, consists of creating an investment fund (association of natural or legal persons) to raise funds from investors and, venture capital invests in unlisted companies as manager of the investment fund. If the investee company fails, the investment is lost. Hence the name venture capital.
Who are the players in venture capital area?
In venture capital, the venture capital firm is made up of general partners and other investment professionals who are called “venture capitalists”. And, although their professional backgrounds vary, their expertise generally comes from the operational or financial field. And their back-office (operating partner) are usually former founders or directors of companies similar to those the company is financing. Venture capitalists with financial expertise usually have experience in investment banking or other corporate finance.
Venture capitalists occupy different positions within the company structure, they can be:
- General partners, manage the company and make investment decisions. They contribute up to 2% of the VC’s capital.
- Venture partners are considered opportunity investors. They are only remunerated for the operations in which they participate.
- Director is a mid-level professional with experience in areas such as investment banking, management consulting, or some other area of interest to the company.
- Senior Associate is a professional with experience and some seniority who has already met certain requirements to grow within the company.
- The associate is a trainee position in a private equity firm. They have some experience in other areas such as investment banking or management consulting.
- Analyst, generally recent graduates who have no previous relevant experience.
- Entrepreneur-in-residence (EIR), are hired temporarily. They are experts in a specific industry sector and perform due diligence on potential deals.
Are the investors part of the startup?
When a venture capital firm decides to invest in a startup, it does so in exchange for a shareholding, generally an equity stake. Thus, with the equity investment, the investor becomes a partner or shareholder of the company. And with this, he also assumes a whole set of administrative and property rights; together with the entrepreneurial risk that we know is high for startups. In this way, the investor becomes part of the startup.
This participation brings with it certain advantages and disadvantages for both parties. For the investor, the biggest advantage is his direct participation in the company that is the object of his investment. Thus, it can influence the production processes with advice and decision making, to guarantee its capital and performance. While for the startup it can mean the development of a dependency that will not allow it to act at its own pace, nor make decisions without the participation of the new investment partner.
The difference of Venture Capital with Private Equity
Perhaps the biggest difference we can appreciate is that while venture capital focuses on people, private equity focuses on the company. Additionally, venture capital focuses more on the potential for the rapid growth of new companies, on the potential of the person or group that manages the company to attract it. While private equity evaluates the long-term potential as it grows and occupies an important niche in the market.
There are also other differences such as:
- Venture capital is used to acquire minority stakes in the company’s assets while private equity buys a controlling or majority stake.
- Venture capital uses only equity capital to make its investments, but private equity tends to combine equity and debt as its primary method.
- Private equity is used with the long-term success of the company in mind, while venture capital is often used to buy many bankruptcies.
How can a startup attract a Venture Capital?
A business plan is essential to obtain financing because it describes the business project, strategic options, and operating methods, as well as the economic prospects and financial needs associated with the project. From the point of view of venture capitalists, the most important thing is the potential of the project. This is the first condition in the investment decision-making process. To influence this decision-making process, you must provide as much information as possible.
Additionally, you should create a good pitch capable of convincing investors in a short presentation. There you can present:
Your market vision, as well as the immense possibilities of your business.
- A complete, but brief, concise, and effective description of the project and the market needs it intends to satisfy.
- The work team that integrates your project.
- A development strategy that the company intends to adopt for its growth.
- And the expected profitability.
Other aspects that will capture the attention of investors include:
- Valuation of the company and the project.
- The amount of investment and the timing of any financial tranche.
- The role of the investor within the company, emphasizing first and foremost, the extent of its influence on operational and strategic activities.
- The protection of the investor’s financial position in the company.
- The investor’s privileges in the “exit”, i.e. the sale of shares or liquidation of the company.