Venture Capital: A Guide to Investing in Startups

Venture Capital: A Guide to Investing in Startups

Many established companies are founded on brilliant ideas. However, excellent ideas can sometimes go only so far without enough financial backing.Startups require significant monetary support to realize their visions and move forward. For several entrepreneurs, venture capital (VC) can provide them with the capital necessary to help them grow in the early stages of their journey.

VENTURE CAPITAL EXPLAINED

VC is a form of private equity that provides capital to startups and new businesses that don’t have much operating history yet but have a high potential for growth in the future.

VC funds invest in young, emerging companies in exchange for equity or an ownership stake. The firm then receives financing, technical support, and managerial expertise in return for selling the stakes. VC investors often play a part in managing the company’s decisions to encourage expansion.

While startup founders are well-versed in the business they established, they could be short of the expertise necessary to support a fledgling company, and VCs have the skills and knowledge to help them do that.

There are also other benefits to working with VCs. For example, portfolio companies gain access to VC funds’ broad connections. Plus, they can seek backing from a VC firm when they plan to raise more funds in the future.

Note that institutional and accredited investors are currently the only type of investors who can access VCs since they are alternative investments. Most common investors of VC funds include pension funds, major financial institutions, high-net-worth individuals, and wealth managers.

VC funds put money into many industries, although most of their investments are focused on the tech sector. Many popular VC firms are headquartered in Silicon Valley, but their bases of operations can also be located throughout the US.

VENTURE CAPITAL AND PRIVATE EQUITY

As mentioned earlier, VC is a form of private equity. It is not precisely private equity, considering it backs startups and business ventures that are yet to achieve considerable profits and revenue.

Moreover, VC firms can only buy stakes that are less than 50% of a company’s equity and can only have an active role in the company’s management.

On the other hand, private equity often invests in well-known companies and typically prefers financially troubled corporations. Additionally, unlike VC, private equity can purchase a majority stake in companies and have an active role in the management and operation of companies.

Perhaps, the only thing that VC and private equity share in common are that they bring in returns once a company is sold or makes a public listing.

UNDERSTANDING VENTURE CAPITAL

Early-stage, growing companies receive funding from VC firms, allowing VC firms to acquire less than a 50% ownership stake in the companies.

A VC fund focuses on driving a startup’s value higher, then profitably selling off its investment and leaving the company.

The VC fund can exit via an initial public offering (IPO), where the company achieves a public listing, letting the VC sell its shares publicly. The VC firm can also sell off the shares on the secondary market.

Typically, there are four types of people involved in a VC: Entrepreneurs, investors, investment bankers, and venture capitalists.

Entrepreneurs: Founders of the company that seeks financial backing to turn their idea into a reality.
Investors: Individuals willing to take huge risks in pursuit of significant profit.

Investment Bankers: People or institutions that require companies to sell a stake or conduct an IPO.

Venture Capitalists: Private equity investors who make money by providing markets for the three individuals mentioned above.

Entrepreneurs submit business plans to VC firms to obtain financial support. If the VC firm sees some investment potential in the plan, it will take the necessary steps to analyze areas such as the company’s business model, operating history, management, and product.

It doesn’t exactly matter how long the company has been in business. The VC firm will take a deep dive into areas of the company that would help it evaluate its business quality and idea. In addition, the VC firm can include the educational and professional background and personal data in its due diligence.

If the research goes well and the company’s growth outlook appears optimistic, the VC firm will proceed to offer capital in exchange for an equity stake. Capital is usually provided in several rounds, and the VC firm will be actively helping manage the company.

Most VC funds are founded on limited partnerships, meaning they are entities that consist of general partners and limited partners working together. General partners handle the fund and its portfolio companies, while limited partners refer to investors in the fund.

The revenue of VC funds is derived from management and performance fees, with 2 and 20 being the most common fee arrangement. In this structure, the VC firm charges investors a 2% management fee on total assets under management (AUM) and a performance fee of up to 20% of the profits.

DIFFERENT STAGES IN VENTURE CAPITAL FUNDING

Portfolio companies go through different stages in the VC funding process as they expand. Some VC funds are experts of certain stages, while others may invest at the time of their choice.

The Seed Stage: The first round of VC funding involves venture capitalists offering small capital to help the new company build its business plan and develop a minimum viable product (MVP) that would please early customers and generate helpful responses for future improvement.

The Early Stage: This stage aims to help young businesses complete the first growth stage. Early-stage funding is divided into three rounds, series A, series B, and series C rounds.

Compared with the seed stage, the funds raised in the early stage are higher since the company’s founders are increasing business operations and activities.

The Late Stage: Late-stage VC financing is typically classified as series D, series E, and series F rounds. Companies that made it to this stage should be bringing in revenue and experiencing strong growth. Their outlook should also appear optimistic even if they are not yet profitable.

VC firms aim to take their portfolio companies to a point where they are good enough to fit the acquisition or IPO category. That way, they can profit from selling off their stakes and allocate the returns to their investors.

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