Venture Capital Investing

A form of financing that provides financial support to small start-up firms and businesses to help them grow and eventually earn profits if they succeed later.

Author: Himanshu Singh
Himanshu Singh
Himanshu Singh
Investment Banking | Private Equity

Prior to joining UBS as an Investment Banker, Himanshu worked as an Investment Associate for Exin Capital Partners Limited, participating in all aspects of the investment process, including identifying new investment opportunities, detailed due diligence, financial modeling & LBO valuation and presenting investment recommendations internally.

Himanshu holds an MBA in Finance from the Indian Institute of Management and a Bachelor of Engineering from Netaji Subhas Institute of Technology.

Reviewed By: Adin Lykken
Adin Lykken
Adin Lykken
Consulting | Private Equity

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The Boston Consulting Group as an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

Last Updated:September 30, 2023

What is Venture Capital Investing?

Venture capital investing involves providing funding to early-stage startups and small businesses by venture capital firms or investors. In exchange for financial support, these investors receive equity stakes in the company.

Venture capital helps startups grow, innovate, and expand, often leading to significant financial returns when the company succeeds.

Venture capital is a form of financing that provides financial support to small start-up firms and businesses to help them grow and eventually earn profits if they succeed later.

So you may want to ask: What can these VC firms get if they invest? The answer is that they can typically get equity or ownership stake from the early-stage company. 

Venture capital financing involves a lot of risks. Venture capitalists risk investing in start-ups due to the uncertainty and high failure rates. 

In recent years, investing in technology has become a trend, including innovative technologies like biotechnology, information technology, artificial intelligence, etc. 

There is no doubt that these high-tech companies usually have great potential for development, but at the same time, they also have high investment risks. It can be said that this high-risk and high-return investment is the charm of venture capital investing.

Everything you need to know about venture capital

VC firms help promising entrepreneurs pool money. But, of course, when the firm invests in entrepreneurs with no operating history, there is undoubtedly potential for loss.

However, if one out of the large number of projects they invest in is successful, then on average, they can still make a profit.

Where do these venture capital companies get the money to invest?

In the beginning, the VC founders proposed to start the company, and some shareholders would invest in it to establish the VC company.

However, at the moment, the companyès only cash flow is from the money invested by shareholders meaning that the amount is not enough to do many investment projects. 

In this case, if the venture capital company wants to invest in more companies, then the venture capital company funds will be set up to attract capital, so that venture capital firms will have more money to invest.

Generally, if a venture capital company invests, it may take a payback period of 5 years, eight years, or even longer. Therefore, it requires a high level of patience for investors and tests the investor's risk tolerance because venture capital risk is also huge.

Therefore, when a venture capital company establishes a fund, a large amount of money may be investments from some wealthy families, which may require an investment quota of tens of millions.

In this case, it is relatively easy for investment companies to raise funds. But, at the same time, investors also have a relatively clear understanding of venture capital, and their risk tolerance may also be extreme.

The process of Venture capital investing

As previously said, venture capitalists like to invest in high-tech start-ups. Unfortunately, these founders have outstanding technical knowledge but little experience in business management.

Because of the unclear aspects of businesses in which they invest, the widespread view is that venture capital is a high-risk investment. Yet, the high rate of return on venture capital is undeniable.

Venture capitalists are both investors and operators. Some venture capitalists have a solid technical background and professional managerial experience.

That is, they can comprehend the business model of high-tech companies. In the meantime, their operating skills can assist entrepreneurs in improving the company's operation and management.

However, we all know that an organization, like a person, has its life cycle, which means that every firm has its life cycle. So when does a company require the assistance of a venture capitalist? First, let's look at its five stages.

Stage 0: Pre-seed round

How are start-up companies funded before they can seek the assistance of a venture capital firm? 

Before the actual seed round, there is a phase known as the "Pre-Seed Stage," during which no professional investor or capital firm participates, but rather the founder's friends, family members, relatives, and, of course, the founder. 

These investors are sometimes the first stockholders.

At this point, the entrepreneur is usually just getting started on their product or service prototype. VCs should not enter the game at this level because there is nothing to examine, no product/services, no concept, nothing.

Pre-seed stage funds are typically tiny, ranging from $50,000 - $200,000. This initial funding stage is usually short-lived, lasting less than a year. However, the actual time varies based on the sort of business.

Stage 1: Seed round

A seed round, which refers to the initial fundraising stage, is where many companies officially raise their first capital. While most startups are funded by the founders or their family and friends, some businesses require "seed capital" from a third party to expand. 

Seed-stage money is typically tiny, mainly used for marketing research, product development, and business expansion to build a prototype to attract other investors in later fundraising rounds.

Seed investing is exceedingly dangerous, and most seed investors know that 70% of startup investments will fail. 

On the other hand, seed investors recognize that in their search for a successful startup, they must "share the risk" with the company and, more crucially, avoid the "Fear of Missing Out" on the next big thing.

Startup owners are subjected to early value, revenue, and customer criteria reviews after receiving seed capital, with stringent timetables for achieving performance. The idea is to raise enough money today to show prospective investors that the entrepreneur can scale and grow.

To help them portray credibility, many seed-stage VCs may pitch subsequent investment rounds simultaneously. During this round, the entrepreneur must demonstrate the business's potential and convince VCs that their idea is a feasible investment prospect.

In addition, a representative from the venture capital firm is likely to join the board of directors to oversee operations and guarantee that everything goes according to plan. The seed funds is normally between $500,000 - $1,500,000.

The VC company will not join at this time. After the first round, venture capital investing occurs in the startup round. 

Stage 2. The startup round (round A)

The startup stage is where VC investors will enter the business. Businesses that have finished research and development (R&D) and developed a business plan are ready to begin advertising and marketing their product or service to potential clients at this stage.

When a VC firm wants to invest in a startup still in the "startup" stage and has yet to launch a viable business, it concentrates on assessing the industry's prospects.

They will consider the team founder's background and executive authority to implement their concept or business plan.

The company has a prototype to offer investors at this stage, which is terrific news, but it has yet to sell any products. 

As a result, at this stage, founders want a more significant infusion of cash to fine-tune their products and services, expand their workplace, recruit a more formal management team, and complete any remaining research needed to support an official business launch.

Stage 3. The first round (round B) 

The "emerging stage" is another name for this third stage. At this stage, the company is prepared to begin operations.

The funds raised during this round of venture capital investment are often used for actual product mass manufacture, marketing, and sales support.

Businesses typically require considerably larger capital expenditure to reach a formal launch. Hence funding amounts at this stage are typically substantially higher than in earlier stages. The amounts range from $1,000,000 to $3,000,000.

Stage 4. The expansion round (round C)

A company is in the expansion stage when it is experiencing rapid growth and needs additional money to keep up with demand. 

Once the company has experienced significant growth, maybe to the point where demand exceeds current capacity, more cash will be required to support expansion and increase profitability.

Since the company has a commercially viable product and is beginning to make some profit, venture capital funding is mainly being used to expand its market, introduce new products, and diversify its product offerings.

The funds' amount for the expansion round is usually more than $3,000,000.

Stage 5. The mezzanine round, the bridge stage

Finally, we arrive at the final stage of venture capital fundraising, dubbed "the bridge stage."

When a company reaches maturity, it enters the bridge stage. Typically, the funds obtained here support activities such as mergers & acquisitions (M&A) and initial public offerings (IPOs). However, the bridge state is fundamentally a stage in the company's development into a packed, successful enterprise.

Many VC investors choose to sell their shares and cease their association with the company at this point, frequently reaping a considerable profit.

After a VC investor successfully assisted a start-up firm to IPO, we must state that it is comparable to a parent raising their child from kindergarten to college.

Bringing a firm to this stage of development is a common aim and aspiration for all VC investors; it is the mark that their investment selection is accurate, and they are ready to profit.

Venture Capitalist

Investors invest venture capital in newly founded or fast-growing emerging companies to offer financiers long-term equity investment and value-added services to cultivate businesses. 

It is an investment that grows quickly and then withdraws funds after a few years through a listing, merger, or other stock transfer process, resulting in substantial investment returns.

The following are some of the most common aspects of venture capital:

1. Venture capitalists typically take an active role in the operation and administration of the company they invest in and provide value-added services.

2. The investment length is at least 3-5 years, and the investment technique is often equity investment which accounts for 15% -20% of the invested enterprise's equity.

3. Investment decisions are made on a highly specialized and procedural basis.

4. When the venture capitalist withdraws from the investment, they can expect to get at least 5-7 times the profit and capital appreciation of the original investment amount.

5. To earn excess returns on their investments, venture capitalists would remove their cash through listing, mergers & acquisitions, or other stock transfer techniques when the invested firm improves in value.

What are the factors VC investors consider?

As it is a high-risk investment, we all know that the probability that an investment project can be supported by venture capital is very low.

After the venture capital projects pass the preliminary screening, the venture capitalists, either in person or through an investment consulting company, begin to conduct due diligence on the project.

The due diligence requires carefully and meticulously conducted investigations on the status quo of the enterprise, the prospects for success, and its management team. Research and examine the product market, personnel quality, economic accounting (verify and determine each number), etc. 

The quality of the management team constitutes the preferred basis for investment decisions, followed by product market growth and ROI.

According to the National Venture Capital Association, the following are the top nine factors a VC investor considering:

  1. Entrepreneurs themselves have the endowment of continuous struggle during the support period.
  2. The entrepreneur is very familiar with the company's target market.
  3. At least ten times the return in 5-10 years.
  4. Entrepreneurial background demonstrates strong leadership skills.
  5. Good risk assessment and response.
  6. Considerable market growth prospects.
  7. Good history related to venture enterprises.
  8. The presentation of the enterprise is straightforward and clear.
  9. Have property preservation measures.

From the report, we can see that the management ability of the operator, the uniqueness of the product, service, or technology, the size of the product market, and investment and exit risks are the main components of the investors' decision-making evaluation.

Researched and authored by Yiqing Qiao | LinkedIn

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