What Is Venture Capital - Types, Stages, And Essential Features

Although it may appear to have existed since the beginning of time, venture capital is a relatively new aspect of commerce and industry. Firms specializing in providing venture capital finance to startup businesses make up modern venture capital.

Venture capital firms, sometimes known as VC firms, invest money in early-stage businesses that they believe can expand and profit. Any startup’s goal is to grow or scale. Startups can expand their client base and thus their absolute profit by raising the scale at which they operate.

What is Venture Capital (VC)?

Venture capital is a type of finance for businesses and an investment vehicle for affluent individuals and institutions. Wealthy investors want to put their money into firms with long-term growth potential. This funding is known as venture capital. The investors are known as venture capitalists; in other words, it is a mechanism for businesses to acquire funds in the short term while investors expand their wealth over time.

Venture capitalists typically invest in early-stage companies, which are riskier due to their illiquidity but have the potential to produce substantial profits if invested in the right venture.

A venture capital firm can fund a company by investing in equity and capital gains, participating in debentures, and granting conditional loans.

Features of Venture Capital investments

High risk

The first characteristic of venture capital is that it is a high-risk activity. As previously stated, venture capital in its modern form invests in new businesses. These are typically businesses that have a novel idea or technology and are driven to profit from it. Today’s big enterprises, such as Facebook, are venture capital-funded startups. We Work is a recent example of a venture capital startup failure, while Facebook is a colossal startup venture capital success story. In late 2019, the coworking space startup came to a halt. This demonstrates that venture capital is a high-risk enterprise with both successes and failures in venture-backed firms. It is estimated that as many as 25% to 30% of venture capital-funded firms fail.

Lack of liquidity

Venture capitalists invest in startups when they are still small businesses. This means that investors have only a few options for recouping their investment: the startup thriving and going public, dividends (which growing businesses rarely pay), or someone else buying it out. Another essential element of venture finance is its lack of liquidity. If things aren’t going well for the startup, the venture capitalist won’t readily exist. They have invested their time and money in the startup. We’ll look at how this venture capital characteristic leads to the existence of a second venture capital feature: managerial participation.

Long term horizon

The time horizon involved in venture capital funding is another significant element of venture capital. Startups require a long time to expand and grow to the point where they can either publicly float their shares or sell their shares to someone willing to buy out the original venture capital investors. Before reaching maturity, many startups go through many investment rounds. More investors are attracted to the company with each game. Meanwhile, these investors will hold on to their equity until their predetermined exit date, which will be discussed later. Before investors can repay their investment, venture capital has a long time horizon.

Equity participation and capital gains

Venture capitalists invest in startups by purchasing ownership in the company, making them part owners. While venture capital has little liquidity and hence requires a long-term investment horizon, venture capitalists earn capital gains on their investments. As the startup’s valuation rises, so does the venture capitalist’s investment value. As new investors join the company and grow, the investor gains capital. Of course, they will only achieve this once they sell their investment.

Meanwhile, venture capitalists retain their vote rights in proportion to their investment. Hybrid equity, such as debentures, has become a characteristic of venture capital funding as the business grows. Debentures are equity shares with a fixed payout similar to interest on the amount invested. In their traditional form, debentures are equity instruments, but their substance is debt finance. Debentures can be redeemable, requiring the startup to purchase back the shares at a predetermined period. This is eerily similar to debt.

Innovative projects

The focus of venture capital is on creative projects. Startups with novel and unique concepts are more likely to get backed by venture capitalists. One of the main reasons for this focus on fresh and inventive ideas is the allure of controlling new fascinating markets. This is why the aforementioned VC-backed businesses Facebook and We Work received investment. Through the concept of social media, Facebook represented a new approach to using the internet for communication. Although social networking as a concept was not entirely novel, Facebook’s policy was, and it paid dividends. WeWork’s approach to coworking spaces was similarly unique, despite the company’s eventual failure.

Management participation

Venture capitalists must participate in company management or reserve the right to participate in management appointments as a condition of investing. Venture capitalists accept a significant risk of failure, and one of the trade-offs is a need to ensure that the startup is handled as efficiently as possible. They may be actively involved or have a say in selecting key jobs like chief financial officer or operations manager. This venture capital feature does not guarantee success, but it does help venture capitalists sleep better at night by giving the startup the best chance of success.

Defined exit

A defined exit is the final venture capital feature we’ll discuss. Venture investors are usually very explicit about how they want to exit a startup when they invest. This could be accomplished by selling the investment on the open market when the firm becomes public through a share buyback program or other means. While long-term investors, it is widely assumed that venture capitalists are interested in the capital to gain their investments generated during a startup’s growth phase. While it’s possible that venture capitalists aren’t interested in investing in a firm eternally, it’s also possible that they are.

Methods of Venture Capital financing

Equity
Participating debentures
Conditional loan

Approaching a Venture Capital for funding as a company

The venture capital funding process typically involves four phases in the company’s development:

Idea generation
Startup
Ramp-up
Exit

Step 1: Idea generation and submission of the business plan

A business plan is the first step in approaching a Venture Capitalist. The following items should be included in the program:

An executive summary of the business proposal should be included.
Description of the opportunity, as well as the size and potential of the market
Examine the current and anticipated competitive landscape
Financial predictions in great detail
Details about the company’s management

The Venture Capital company conducts a thorough review of the presented plan before deciding whether or not to proceed with the project.

Step 2: Introductory meeting

Once the VC has completed their preliminary research and found a project that meets their criteria, a one-on-one meeting is scheduled to discuss the proposal in greater depth. The VC then decides whether or not to proceed to the due diligence stage of the process after the meeting.

Step 3: Due diligence

Depending on the nature of the business proposal, the due diligence step may differ. You’ll be answering questions about customer references, product and company strategy evaluations, management interviews, and other information exchanges during this time.

Step 4: Term sheets and funding

If the due diligence step goes well, the VC will offer a term sheet, a non-binding document explaining the investment agreement’s basic terms and conditions. The term sheet is often negotiable and must be agreed upon by all parties, after which funds are made available following the completion of legal documentation and due diligence.

Types of Venture Capital funding

The many types of venture capital are classified according to their use at different stages of a company’s life cycle. Early-stage funding, growth financing, and acquisition/buyout financing are the three main types of venture capital.

The venture capital financing process is completed in six steps, each corresponding to different stages of a company’s development.

Seed money is a small amount used to test and develop a fresh idea.
Startup: Funding is required for new businesses to cover marketing and product development costs.
Manufacturing and early sales funding are covered in the first round.
Second-Round: Operational money provided to early-stage businesses selling items but are not profitable.
Third-round financing, often known as mezzanine financing, is money used to expand a new profitable business.
Fourth-Round Financing: Also known as bridge financing, fourth-round financing is intended to fund the “going public” process.

Early-stage financing:

Early-stage financing has three subdivisions: seed financing, startup financing, and first-stage financing.

Seed financing is a small amount that an entrepreneur receives to qualify for a startup loan.
Startup financing is given to companies to finish developing products and services.
First Stage financing: Companies that have spent all their starting capital and need finance for beginning business activities at the full-scale are the primary beneficiaries of the First Stage Financing.

2.Expansion financing:

Second-stage financing, bridge financing, and third-stage financing, often known as mezzanine financing, are all types of expansion funding.

Second-stage finance is given to businesses to help them get started on their expansion plans. Mezzanine finance is another name for it. It is offered to support a specific company that is expanding significantly. Companies that use Initial Public Offerings as a primary business strategy may be eligible for bridge financing as a short-term interest-only loan or as a kind of monetary support.

3.Acquisition or Buyout financing:

Acquisition finance and management or leveraged buyout financing are two types of acquisition or buyout financing. Acquisition financing enables a corporation to purchase specific components or the entire company. Management or leveraged buyout finance allows a group of executives to acquire a particular product from another company.

Venture capital advantages and disadvantages

Advantages of Venture Capital

They contribute to the organization a wealth of knowledge and experience.
A large amount of equity capital can be offered.
The company is not in a position to return the funds.
It gives essential knowledge, resources, technical expertise, and funding to help a firm succeed.

Disadvantages of Venture Capital

The founder’s autonomy and authority are lost as the investors become part owners.
It’s a time-consuming and challenging procedure.
It is a risky method of funding, and its benefits can only be recognized over time.

Exit route

There are various exit options for Venture Capital to cash out their investment:

IPO
Promoter buyback
Mergers and Acquisitions
Sale to another strategic investor

Examples of Venture Capital funding

Kohlberg Kravis & Roberts (KKR), one of the world’s top alternative investment asset managers, has signed a definitive deal to invest USD150 million (Rs 962 crore) in JBF Industries Ltd, a Mumbai-based listed polyester manufacturer. In its Singapore-based wholly-owned subsidiary JBF Global Pte Ltd, the company would buy a 20% ownership in JBF Industries and invest in zero-coupon compulsorily convertible preference shares with 14.5 percent voting rights. JBF will be able to complete its ongoing initiatives thanks to the finance granted by KKR.
In a new round of fundraising sponsored by Goldman Sachs and Zodius Technology Fund, Pepperfry.com, India’s largest furniture e-marketplace, has raised USD100 million. The cash will be used to increase Pepperfry’s footprint in Tier III and Tier IV cities by adding to the company’s growing fleet for delivery vehicles. It also plans to create new distribution hubs and increase its carpenters and assembly workers network. This is the most significant money ever raised in India by a sector-focused e-commerce company.

Venture capitalist examples

The Pareto principle governs venture capital returns: 80% of the profits come from 20% deals. Great venture capitalists invest understanding that they’ll have to incur a lot of losses to accomplish those successes.

The “Babe Ruth effect,” named after the iconic 1920s-era baseball player, has been coined by Chris Dixon of venture company Andreessen Horowitz, a CB Insights Smart Money VC. Babe Ruth had a lot of strikeouts, but he also had a lot of hits.

WhatsApp

In 2014, Facebook paid $22 billion for WhatsApp, making it the largest private acquisition of a VC-backed firm. Sequoia Capital, the company’s sole venture backer, saw its $60 million investment grow into $3 billion.

Sequoia’s success was predicated on exclusive cooperation with Brian Acton and Jan Koum, the founders of WhatsApp.

When early-stage investors put money into a firm, they usually want to bring in more money to generate more publicity and legitimize their investment. A startup’s cap table may have as many as five or six different VCs. Because of this, these rounds are frequently referred to as “party rounds.”

WhatsApp and Sequoia Capital took a different approach: Sequoia was the sole investor in WhatsApp’s $8 million Series A investment in 2011, valued at $80 million.

Sequoia was also the sole investor in the Series B round that followed.

WhatsApp’s founders have a reputation for being outspoken. For example, it published an anti-advertising credo early in its history, vowing that it would never profit from placing ads in the service and interfering with users’ experiences.

It’s not surprising, then, that they chose to cultivate a single venture capitalist as an outside source of cash despite only raising $60 million in external equity funding.

Even as the service rose to a billion users, Sequoia underlined its belief in WhatsApp’s bright future. Firms that invest with such conviction receive a more significant percentage of ownership than those that enter a deal with a crowded field of other VCs.

By the time Twitter had collected $60 million, it had attracted more than a dozen outside investors. Union Square Ventures, the primary Series A investor, owned only 5.9% of Twitter when leaving. On the other hand, WhatsApp had started from the start when it wanted to collaborate with only one company.

Sequoia’s well-known track record as a Silicon Valley kingmaker, as well as its vast funds, helped it win the deal over Felicis Ventures and others. Sequoia Capital invested an additional $52 million in WhatsApp’s Series A in July 2011, after initially investing $8 million in the company’s Series A in April 2011.

Sequoia paid an eye-popping 75x+ revenue multiple for its shares when it invested an additional $52 million at a $1.5 billion value. WhatsApp was producing $20 million in revenue at the time.

It was well worth it. Sequoia had put in a total of $60 million for an 18 percent stake in WhatsApp when Facebook bought it for $22 billion. Its stock was worth more than $3 billion, representing a 50-fold return.

Facebook purchasing WhatsApp was an excellent result for Sequoia for another reason.

Mark Zuckerberg had come up late to a Sequoia pitch meeting ten years before (egged on by Sean Parker, who had a grievance against partner Michael Moritz).

The meeting was staged as a joke, and Zuckerberg had no intention of allowing Sequoia to invest. He showed there in his pajamas and gave “The Top Ten Reasons You Should Not Invest,” a Letterman-inspired anti-pitch deck.

“I assume we really offended them, and now I feel really bad about that,” Zuckerberg later told journalist David Kirkpatrick.

Selling WhatsApp back to Mark Zuckerberg for $3 billion or more must have taken some of the strings off of that experience. In addition, he was not invited to invest in one of the most prestigious venture capital acquisitions of all time – Facebook.

2.Facebook

Facebook’s $16 billion IPO at a massive $104 billion valuation was an enormous win for early investors Accel Partners and Breyer Capital. The businesses led a $12.7 million Series A investment into Facebook in 2005, purchasing a 15% stake in what was then known as “Thefacebook.”

At the purchase, the company was valued at an astounding $100 million. Investors wouldn’t start pouring money into the early social media startup until nearly a year later.

In 2006, the $27.5 million Series B investment was made by Founders Fund, Interpublic Group, Meritech Capital Partners, and Greylock Partners valuing Facebook at $418 million.

Accel Partners’ stake in Facebook was worth $9 billion when it went public in 2012, even after selling $500 million in shares in 2010. This provided Accel Partners with a substantial return on its investment. As a result of this investment, Accel’s IX fund became one of the best-performing venture capital funds in history.

It was also a wager that failed for Peter Thiel, its first investor. Thiel became an outside board member of Facebook in 2004 after making a $500K startup investment. According to Thiel, Facebook had a “very realistic valuation” at the time. With a $500K seed investment, he puts his money where his mouth is.

Thiel observed Facebook’s dramatic climb to stardom firsthand. He never partnered with Accel and Breyer again because he thought the firm was overvalued. When Facebook raised its subsequent Series A barely eight months after Thiel’s initial investment, Thiel (and much of Silicon Valley) thought Accel had overpaid.

Thiel made a common mistake: he underestimated exponential growth. When comparing the IPO valuation to trailing revenue ratio of Facebook to that of subsequent exits Twitter and Snap, it becomes clear that Facebook was highly undervalued at its IPO.

Thiel later regarded missing out on the Facebook round as his biggest blunder — and the one that taught him the most about how to approach a company that “appears” to be pricey. He went on to say, “Our basic life experience is fairly linear.” Humans badly devalue exponential things. Many, if not all, VCs view a company’s up round with a significant increase in valuation to be too great and underprice it.”

It’s tough to discern how today’s world works. It’s difficult to see how Facebook was ever “overvalued,”especially today. While Facebook’s two billion+ active users are astounding, its early exponential growth is more so.

In 2006, when it was still primarily targeted at college students, Facebook had around 12 million users. Given that between 15M and 20M people enroll in college each fall, there was still a potential (at this stage) that Facebook would stay in its academic niche and fade away once it was introduced to the rest of the world.

Investors had no means of knowing whether or not people would stay after graduation. They had no idea how well it would be received outside of academia, and eventually, in other countries. That’s why Thiel and others thought Accel and Breyer’s $100 million investment was excessive.

In hindsight, it’s evident to Thiel that Facebook’s growth did not follow a predictable, linear path. In reality, it was growing at an exponential rate, and the company was undervalued.

Of course, Thiel is being provocative in part. It’s also likely that some expensive rounds will not shake out.

Everything boils down to faith. To persevere in the face of a significant valuation spike, an investor must have strong convictions in the company. When you have strong convictions, you may do whatever it takes to expose yourself to as much upside as possible, as Eric Lefkofsky did after assisting in the founding of Groupon.

3.Groupon

Since Google went public in 2007, Groupon’s IPO in 2011 was the largest by a US web company. The IPO raised $700 million and valued Groupon at over $13 billion. New Enterprise Associates’ 14.7 percent investment in Groupon was valued at around $2.5 billion at the end of the first day of trading. Eric Lefkofsky, Groupon’s largest shareholder,was the most outstanding winner from the IPO.

Lefkofsky was a co-founder, chairman, investor, and the largest shareholder of Groupon. He positioned himself on both sides of the Groupon deal through numerous privately-owned financial vehicles and management responsibilities. How he accomplished this was divisive. However, he ended up owning 21.6 percent of the corporation. When Groupon went public in 2011, he had a $3.6 billion stake.

It all began when Lefkofsky assisted in the launch of Groupon. When Mason started doing contract work for Lefkofsky, he met Groupon co-founder Andrew Mason. Mason told Lefkofsky about his idea for The Point, a crowd-sourced voting platform, in 2006.

Lefkofsky and Brad Keywell invested $1 million in The Point in 2007. The Point was in trouble by 2008. Lefkofsky noted that some customers had taken advantage of the platform to buy things in bulk and receive a discount. Lefkofsky assisted Mason in pivoting The Point into the company we now know as Groupon, seeing that this one-off use case could spin out into a far more profitable business.

In later rounds of investment, Groupon enlisted the help of New Enterprise Associates (NEA) for its Series B round. Following that, Groupon attracted New Enterprise Associates (NEA) for its Series A, Accel for its Series B, DST for its Series C, and Greylock Partners, Andreessen Horowitz, Kleiner Perkins Caufield & Byers, and others for its $950 million+ Series D. But none of those investors fared as well at the IPO as Lefkofsky.

4.Flipkart

E-commerce was virtually non-existent in India in 2008, and even brick-and-mortar retailers were struggling. But it wasn’t until then that Accel decided to put $800,000 into the online store Flipkart as an initial investment.

In 2018, Walmart spent a stunning $16 billion to acquire Flipkart, valuing the e-commerce company at $20.8 billion. What may have been a miscalculation turned out to be one of a private venture-backed firm’s most significant deals ever made. Flipkart’s investors were rewarded handsomely due to the acquisition, including early champion Accel, who made $1.1 billion.

Walmart acquired 77 percent of Flipkart in the deal, making it the corporate parent of the Indian e-commerce firm. The agreement aided the US retailer in its battle with Amazon for a piece of India’s valuable market. It was one of Accel’s most significant global exits, and it solidified Accel India’s position as a winner’s market.

Despite a growing middle class, most people still went to their local businesses in 2008. Except for travel, such as rail and flight tickets, they didn’t trust internet purchases. There was also no infrastructure in place to ship items throughout India.

Sequoia Capital, for example, passed on Flipkart. But Accel saw something in the founders, Binny Bansal and Sachin Bansal, two former Amazon employees who believed they could create a similar e-commerce company.

Accel had just opened an office in India, and the partners later commented that they were looking for “unconventional and ambitious firms.” India and other emerging markets are high-risk, high-reward investments. Accel’s India fund is now semi-independent, focusing on early-stage startups and predominantly Indian partners.

Even now, 60% of Accel India’s portfolio is in the seed stage, with most other investments in Series A and B. This results in a flexible staff engaged with the ecosystem’s standouts.

While it’s fashionable for investors to state they’re looking for visionary entrepreneurs. This is only one of the crucial characteristics to look for in these growing sectors. Founders must also have a thorough understanding of the problems they’re dealing with and be willing to try out fresh ideas. The Accel India partners perceived the Bansals in this light.

Flipkart constructed the infrastructure that firms in the developed world take for granted from the ground up to make its vision a reality. This comprised a nationwide logistics network as well as delivery fleets. Cash on delivery, doorstep debit/credit payments and monthly installments are just a few of the company’s innovations to make online shopping more appealing.

Investors jumped aboard and injected approximately $7 billion into the company over the next decade after the ball got rolling. To name a few, Tiger Global, Naspers, SoftBank, Morgan Stanley, Tencent, and Microsoft were among the global investors. Despite multiple management changes and the eventual resignation of both founders, Flipkart has remained the most popular e-commerce platform.

5.Spotify

When Spotify went public on April 3, 2018, it was valued at $29.5 billion, and many investors profited. However, Creandum, a small Swedish VC firm and early investor received an 80x return. Creandum invested around $4.5 million in the company, giving it 6% ownership. Its share in the company was valued at $370 million at leaving.

Creandum led the initial venture round for the also-Swedish startup, but it wasn’t love at first sight. Creandum and Spotify met regularly for 18 months before investing in chatting and consulting. Those discussions established a strong personal bond between Creandum and Spotify and provided Creandum with an inside perspective on whether or not to invest. It happened in the end.

Spotify grew from an unknown Swedish company to the world’s most popular on-demand music streaming service in the decade following Creandum’s financing.

Stockholm-based When Creandum first looked at Spotify in 2007, it was far from a sure bet. The majority of investors were unwilling to touch it. The music industry was dangerous, had razor-thin margins, and caused a slew of issues regarding bargaining with executives.

Fredrik Cassel, a Creandum partner, later said that he was doubtful of the co-founders’ assertion that the service could play any song in the world. The Bear Quartet, a relatively unknown Swedish act, was named by Cassel. Spotify, to his surprise, pulled up every song the band had ever recorded.

Simultaneously, there was no simple or even totally legal way to make money from downloading music. Napster was shut down in 2001 after running afoul of the music industry over copyright issues. Others attempted to fill the void, but their efforts resulted in costly lawsuits. Kazaa, for example, was not only owed millions of dollars, but it also put its customers at risk, as the robust music industry threatened Kazaa’s users with piracy lawsuits.

Despite this, many consumers gambled on obtaining music from one of a slew of quasi-legal businesses that popped up and disappeared. If Spotify succeeded, its creators understood it had to outperform the competition. “This has to be better than piracy,” their declared goal was.

There are considerable entry hurdles and challenging markets, but there are also significant benefits. On the other hand, investors can’t just throw money at a firm; they have to put in the effort to create a connection with the company so that when news gets out about its success, they’ve earned a seat at the table.

Investors began to recognize Spotify’s potential as the first round came together. Ek and Lorentzon were picky about who they invested with, and their connection to Cassel sealed the deal.

“We were closer to the company than almost anybody else in the venture sector,” Cassel explained, “which allowed us to pull the trigger and invest.”

Creandum secured a large portion of what would turn out to be the future by adopting this blueprint.

Want to make a career in Venture Capital?

The venture capital business is flourishing, and finance professionals and analysts are in high demand. Candidates interested in pursuing a career in venture capital require a specific skill set and, as a result, specialized training in the finance sector. Financial Modeling can teach candidates the abilities they need to get started in the Venture Capital market entry-level. Financial Modeling teaches students to use various models to track a company’s performance. Other elements such as risk, growth rate, revenue, expense, and so on are estimated and forecasted using these financial models.

A candidate seeking full-fledged training as a Financial Analyst should enroll in a professional accounting or finance course to get industry-relevant skills and study the procedures employed in the field.