Introduction
The establishment and expansion of new businesses is acknowledged as one of the most essential components for economic expansion. Young enterprises at the beginning of a development phase typically have difficulty gaining access to traditional financing due to their short track record and lack of stable cash flows. Financing the business with the entrepreneur’s resources is typically not a viable option because these assets are either already in use or insufficient. In addition, it is uncommon for new enterprises with a rapid growth rate to be able to generate the necessary capital internally. Lastly, equity financing is preferable to debt financing for financing the investments and expansions of young, expanding businesses.
Venture Capital firms are firms that specialise in investing in startups. In order to do so, they must not only give funds for expansion, but also provide essential expertise to enable the startup to expand. Investors in Venture Capital funds are often very big organisations, such as pension funds, banking businesses, insurance companies, and university endowments, who spend just a small portion of their overall wealth in high-risk projects. They anticipate a return of between 25 and 35 percent each year during the investment’s lifespan.
In this article, we’ll start with the Components of a Venture Capital fund. After this, we’ll have a look into how Venture Capital firms make Money, and in the letter part of this post, we’ll understand how VC firms are essential for startups.
Components of a Venture Capital Fund
There are two essential components of a Venture Capital fund:
- General Partners; and
- Limited Partners.
The General Partners are responsible for making investment decisions (locating and negotiating agreements with startups) and assisting startups in achieving their objectives. On the other side, Limited Partners are the individuals and organisations that offer the required funds to execute these transactions. In other words, Limited Partners give the capital while General Partners make the investments. This is a major distinction between Venture Capital funds and other investment vehicles: The capital of Limited Partners, such as pension funds, public venture funds, endowments, hedge funds, etc., is invested by Venture Capital funds. General partners may invest some of their own money via the fund, but this is typically less than one percent of the fund’s total size.
How Venture Capital Firms Make Money
The transition from an early stage startup to a mature company increases the complexity of business operations and imposes new demands on the management of the firm on a continuous basis. In general, Venture Capital firms specialise in helping startups scale their business without losing their own uniqueness in their product offerings.
Venture Capital funds generate revenue in two ways: through management fees and carry (carried interest). Both of these are described below:
- Management costs: Management fees are typically characterised as the “expense of professionally managing your assets.” What implications does this have for the Venture Capital industry? As a type of income and a mechanism to offset organisational and fund expenditures, Venture Capital funds often pay an annual management fee to the fund’s management firm. Typically, management fees are established as a proportion of the fund’s capital commitments, between 2 and 2.5 percent.
- Carried interest or carry: A portion of the earnings of an investment or investment fund paid to the investment management in excess of the amount contributed by the manager to the partnership. This is how Wikipedia defines the term “carry.” When an investment is profitable, the carry reflects the fund managers’ part of the earnings. Typically, carried interest in Venture Capital is between 20 and 25 percent, which means that while 20 percent of the earnings are allocated to the general partners, 80 percent are allocated to the limited partners.
How does the Venture Capital Industry Work?
There are four major participants in the Venture Capital industry: entrepreneurs who need funding, investors who want big returns, investment bankers who need to sell firms, and Venture Capitalists who earn money by creating a market for the other three.
VC firms often mitigate risk by co-investing with other companies. There will typically be one “lead” investor and numerous “followers.” It is not typical for a single VC to finance the entirety of a single firm. Rather, Venture Capital firms want to include two or three parties in the majority of funding rounds. These ties give additional portfolio diversification, or the potential to invest in more projects per dollar of cash. Involving others in identifying the risks during the due diligence stage and managing the transaction also reduces the strain of the Venture Capital partners. In addition, the presence of many VC firms lends legitimacy. In fact, some analysts believe that the genuinely intelligent fund will always be a follower of the leading corporations.
As businesses expand, they progress through the various stages of Venture Capital. In addition, businesses or investors may concentrate on particular stages, which influences how they invest.
• Seed phase
VC Firms rarely get involved in this stage, since it is too early for them to see a promise in the startup. In general, a seed round is when a venture investor offers a very modest amount of funding to an early-stage firm for product development, market research, or business plan creation. As its name indicates, a seed round is frequently the first official round of fundraising for a startup. In exchange for their investment, seed round investors often get convertible notes, equity, or preferred stock options.
• Initial phase
Early-stage Venture Capital investment is designed for businesses in the development phase. This level of funding is often greater than the seed stage because once a firm has a marketable product or service, it requires more funds to begin operations. The rounds or series in which Venture Capital is invested are marked by letters: Series A, Series B, Series C, etc.
• Late phase
Late-stage Venture Capital financing is reserved for established businesses that may or may not be profitable, but have demonstrated growth and are producing revenue. Similar to the initial phase, each round or series is denoted by a letter. Series D, Series E, and Series F are the most usual late-stage investment rounds, but Series G and beyond is also possible.
If a company in which a Venture Capital firm has invested is successfully purchased or goes public, the firm earns a profit and distributes returns to its limited partners. The company might potentially earn a profit by selling part of its shares on the secondary market to another investor.
How VC firms influence startups?
Venture Capital firms, known for investing in startups, have garnered huge attention due to their influential role in the establishment of young companies. VC firms offer not only financial investment, but also valuable intangible assets based on their experience and network. This aspect of VC investment is critical, as young firms often lack both financial and intangible resources, including past experience and knowledge, which are necessary for them to develop their business. However, only a limited number of startup firms have been successful in attracting VC investment and the timing of receiving investments ranges from the initial stage to the later stage of startup growth. From this perspective, the impact of VC investment depends on the stage of investment, and the startup’s ability to execute as per the needs of the market.
From its establishment, a firm goes through a step-by-step development process. Understanding startups’ growth stages are useful for investigating how VC investment can help them achieve scale and growth. As the resources secured from VC firms also play different roles according to each stage of development, it is essential to consider at which stage the startup is while securing funding. For instance, different market positions determine the resources required for a startup depending on its stage of growth. Choosing the right VC based on startup’s requirements and VC firm’s expertise will heavily influence the growth of the startup.
The current stage of the VC fund also plays a very critical role in the growth of the startup. A Venture Capital fund has a limited lifespan of around 10 years, resulting in three- to five-year investment cycles. In such cases, if a startup gets funded at the late stage of the fund’s lifecycle, the startup will be under high pressure to show results, else the VC firm might take drastic steps for liquidation. However, if a startup gets funded in the early stage of the fund’s lifecycle, the startup will have more time to perform, and might even get even more funding from the same firm in the next stage. Understanding the VC firm’s current fund stage is very important, and not taking this into account might prove very costly to the startup.
Conclusion
Globally, Venture Capital is now regarded as playing a crucial role in innovation, wealth creation, and job creation, and it is a growing component of both national and subnational government attempts to stimulate economic growth. VC firms carefully select the startups they invest in. The general preference is around best performing ones, but VC firms might also choose startups that are not promising now but could unlock their potential with right guidance.
Even though getting VC funding is beneficial for startups, a startup still needs to evaluate whether it’s a good fit for their requirements. A misstep could prove very costly, even leading to bankruptcy, losing the entire stake, and much more. Startups should evaluate whether a VC firm is the best choice for them and plan accordingly.
