Venture Capitalists

What Is a Venture Capitalist?

Venture capital is a form of equity financing for small businesses. A venture capitalist is similar to a mutual fund manager who finds equity investments for a pool of investors. However, unlike mutual fund managers, venture capitalists focus on high-risk entrepreneurial businesses. 

They provide start-up (seed money) capital to new ventures, development funds to businesses in their early growth stages, and expansion funds to rapidly growing ventures that have the potential to "go public" or that need capital for acquisitions.

Investors who support start-up enterprises and early-stage companies with significant growth potential are known as venture capitalists (VCs).

They often make investments in exchange for equity or ownership in the business with the goal of making a sizable return on their money by promoting the expansion of the business and the ultimate sale or IPO.

VCs often look for innovative and disruptive technologies or business models and are willing to take on higher risks in exchange for the potential for higher rewards.

VCs contribute significantly to the startup ecosystem by offering financial support and crucial resources like knowledge, contacts, and mentorship.

Additionally, they aid in bridging the gap between early-stage businesses and more conventional financing sources like banks or public markets. Angel investors and venture capitalists differ significantly because the former typically invest early in a company's development while the latter do so later.

Understanding Venture Capitalists

Venture capital firms are limited partnerships of money managers who raise money in “funds” to invest in start-ups and growing firms. The funds are raised from high-net-worth individuals, pension plans, university endowments, foreign investors, etc.

The investors who invest in venture capital funds are known as limited partners. The venture capitalists who manage the fund are called general partners.

The venture capitalist receives an annual management fee in addition to 20 to 25% of the profits earned by the fund. The percentage of the profit the VCs get is called carry.

For example, if a venture capital firm raised a $100 million fund and the fund grew to $500 million, a 20 percent carry means that the firm would get, after repaying the original $100 million, 20% of the $400 million in profits, or $80 million.

Stages of Venture Capital Funding

Let’s understand the various stages while raising funds through venture capital:

It's important to note that not all startups go through all of these stages. The exact amount of funding for each stage can vary based on the industry, the startup's growth trajectory, and the specific investment opportunities available.

Criteria for investment

Although the venture capital industry is evolving toward larger and more complicated financing, smaller deals will need to be funded through individual capitalists attracted to high-risk new ventures.

Criteria most frequently used by a venture capitalist as investment decision guidelines:

Relationship with venture capitalists

Entrepreneurs seek out venture capitalists for their money, and venture capitalists envision long-term business relationships with entrepreneurs. Most VCs maintain frequent contacts helping businesses and act as “mentors.” 

These relationships are as follows:

• Providing management and board decision advice.
• Introducing them to suppliers, management consultants, and distributors.
• Linking relationship between entrepreneurs and lenders.
• Developing relationships with securities firms and brokers.
• Monitoring all investor’s interests through involvement.
• Finding key resources, locations, or facilities.
• Motivating entrepreneurs through personal assistance.
• Facilitating expansion financing or IPO underwriting.
• Providing technical assistance on products and innovations.
• Acting as guarantors on loans or leases.
• Developing new customers or new markets through networking.

Venture-capital industry

The first step toward institutionalizing the capital industry took place in 1946 with the formation of the American Research and Development Corporation(ARD) in Boston. The ARD had a small pool of capital from individuals and institutions put together by General Georges Dorior to make active investments in selected emerging businesses.

The next major development, the Small Business Investment Act of 1958, married private capital with government funds to be used by professionally managed small-business investment companies (SBIC firms) to infuse capital into start-ups and growing small businesses. 

With their tax advantages, government funds for leverage, and status as a private-capital company, SBICs were the start of the new formal venture-capital industry.

During the late 1960s, small private venture-capital firms emerged. These were private venture-cal usually formed as limited partnerships, with the venture-capital company acting as a general partner that received a management fee and a percentage of the profits earned on a deal.

Another type of venture capital firm was also developed during this time: the venture-capital division of major corporations. 

In response to the need for economic development, a fourth type of venture-capital firm emerged as the state-sponsored venture-capital fund. 

These state-sponsored funds have various formats. While the size and investment focus and industry orientation vary from state to state, each fund typically must invest a certain percentage of its capital in a particular state. 

There are now emerging university-sponsored venture-capital funds. These funds, managed as separate entities, invest in the technology of the particular university. 

At such schools as Stanford, Columbia, and MIT, students assist professors and other students in creating funding plans and assist the fund manager in his or her due diligence, thereby learning more about the venture capital funding process.

Venture-capital process

The venture-capital process can be divided into four primary stages: preliminary screening, agreement on principal terms, due diligence, and final approval.

The preliminary screening begins with the receipt of the business plan. A good business plan is essential in the venture capital process. Most venture capitalists will not even talk to an entrepreneur who doesn't have one.

As the starting point, the business plan must have a clear-cut mission and clearly stated objectives supported by an in-depth industry and mark analysis and pro forma income statements. 

The executive summary is an important part of this business plan, as it is used for initial screening in this preliminary evaluation. Many business plans are never read beyond the executive summary. 

The second stage is the agreement on principal terms between the entrepreneur and the venture capitalists. 

The venture capitalist wants a basic understanding of the principal terms of the deal at this stage of the process before making the major commitment of time and effort involved in the formal due diligence process.

The third stage, detailed review, and due diligence is the longest stage involving anywhere from one to three months. There is a detailed review of the company's history, the business plan, the resumes of the individuals, their financial history, and target market customers. 

The upside potential and downside risks are assessed, and the markets, industry, finances, suppliers, customers, and management are thoroughly evaluated.

In the last stage, final approval, a comprehensive internal investment memorandum is prepared. This document reviews the venture capitalist’s findings and details the investment terms and conditions of the investment transactions to finalize the deal.

Conclusion

Venture capital may be used in the first stage, but it is primarily used in the second or third stage to provide working capital for growth or expansion. Venture capital is broadly defined as a professionally managed pool of equity capital. 

Since 1958, small-business investment companies (58ICs) have combined private capital and government funds to finance the start-up and growth of small businesses. 

Private venture-capital firms have developed since the 1960s, with limited partners supplying the funding. At the same time, venture-capital divisions operating within major corporations began appearing. States also sponsor venture-capital funds to foster economic development.

To achieve the venture capitalist's primary goal of generating long-term capital appreciation through business investments, three criteria are used: 

• The company must have strong management, 
• the product/market opportunity must be unique; and 
• The capital appreciation must be significant, offering a 40 to 60 percent return on investment. 

The process of obtaining venture capital includes a preliminary screening, agreement on principal terms, due diligence, and final approval. Entrepreneurs must approach a potential venture capitalist with a professional business plan and a good oral presentation. 

Research and Authored by Riya Choudhary | LinkedIn

Reviewed and Edited by Parul Gupta | LinkedIn

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