Venture Capital - A Simple Overview

Introduction

First developed as an industry after WW2, venture capital grew rapidly as an industry but was hit heavily by the 2008 financial crisis. However, with the emergence of unicorns (private startups valued over $1 billion) and an increase in economic confidence venture capital expanded, with it being most concentrated in West Coast America. VC investment totalled $684 billion in 2021 and $445 billion in 2022.

Chain 1: What is Venture Capital?

Venture capital (VC) is a form of financing (private equity) that investors provide to support high-growth potential start-ups and businesses. In exchange for their investment, VC firms receive equity in the start-up (usually a minority stake), becoming shareholders and sharing in the potential success of the business. VC firms typically adopt a long-term view and invest with the expectation of achieving significant returns if the start-up is acquired or goes public. Venture capital can also come in the form of technical advice/management, with companies such as Xpdite Capital Partners providing accelerator programmes which aim to increase the growth rates of the companies they are nurturing.

Chain 2: Why are VC firms needed?

Venture capital plays a crucial role for early-stage companies that do not have access to equities markets or are unable to undertake debt financing due to its limited operating history, unproven business models, and a lack of collateral. VC funds enable nascent businesses to flourish by providing the necessary funding and support to bring their innovative ideas to life.

The venture capital industry has experienced significant growth in recent years, with fundraising and investments reaching record levels. This growth can be attributed to factors such as recycled liquidity from an active exit market (when investors exit the market the cash generated from the sales is reinvested) and the increased participation of non-traditional investors, including private equity firms, corporate venture arms, hedge funds, and sovereign funds.

Chain 3: How do start-ups get access to Venture Capital?

Initially, startups often rely on personal funds from founders, friends, and family members to bootstrap their operations. As the start-up grows and requires additional capital to scale, founders seek more formal sources of financing: VC firms.

In most cases VC firms form limited partnerships where partners (wealthy individuals, pension funds, insurance companies etc) pool their money into a fund controlled by the VC firm which then decides where the money will be invested.

To get access to this venture capital the start-up submits a business plan and pitch deck and to a VC firm that aligns with their vision and business model. If investors are impressed by the pitch deck and business plan, they conduct due diligence to assess the start-up's viability. This includes analysing the business model, products or services, financial position, and performance. If both parties decide to move forward, the venture investor presents a term sheet outlining the investment amount, expected equity stake, and other conditions of the deal. VC funding is often structured in multiple rounds over several years, with certain conditions to be met before each round is released. After around five years, the VC firm will exit the company by initiating an initial public offering (IPO), merger or acquisitions.

Chain 4: Pros and Cons of Venture capital

For start-ups, working with a VC firm allows them to receive funding to help grow the business and increase the rate of success. Beyond the funding venture capitalists provide valuable mentoring and guidance and can leverage their experience and networks to help start-ups build strategies, access resources, additional investor contacts, and recruit talent. Unlike loans, venture capital does not require repayment if the start-up fails, providing entrepreneurs with more flexibility and cash flow. For the VC firm, they obtain some of the companies’ equity which they hope will grow in value rapidly and therefore yielding a high return on investment when the VC firm exits the company. An example of the large VC success can be seen in Sequoia’s $60 million investment into WhatsApp for 18% ownership, which was then bought by Facebook for $22 billion meaning Sequoia’s share was worth $3 billion, A 50x return.

While venture capital provides significant advantages, there are considerations and potential challenges for the start-up. The process of securing venture capital can be time-consuming, requiring the development of a compelling pitch deck, business plan, and subsequent negotiations. As mentioned, Venture capitalists typically take a portion of start-up’s ownership and may join the board of directors, influencing decision-making processes. As such, because VC firms often expect a high return on their investment within a relatively short time frame, they may pressure start-ups in various ways. For example, start-ups may have to end up abandoning long term growth investments because their incremental funding is based on short term business milestones or VC firms may demand the to exit through a sale or initial public offering (IPO), potentially undervaluing the company. For the VC firm investing in a start-up is risky due to their high rates of failure. One notorious example being the company Webvan which valued at $1.2 billion went bankrupt in 2001, eating through $800 million in venture capital.

Conclusion

In summary, venture capital plays a crucial role in supporting the financial needs of rapidly growing start-ups, offering funding, guidance, and invaluable connections. It empowers emerging businesses to develop by surpassing the constraints of conventional financing alternatives. Nevertheless, the pursuit of VC funding can be rigorous, and start-ups need to navigate potential obstacles, including relinquishing ownership and dealing with the expectation of swift returns.

References

https://hbr.org/1998/11/how-venture-capital-works

https://www.forbes.com/advisor/investing/venture-capital/

https://www.investopedia.com/terms/v/venturecapital.asp

https://www.investopedia.com/terms/v/venturecapitalist.asp

https://www.svb.com/startup-insights/vc-relations/what-is-venture-capital

https://medium.com/@CBinsights/the-top-5-vc-bets-of-all-time-72bff048e661

https://venturebeat.com/business/20-worst-vc-investments-of-all-time/

https://www.emergingtechbrew.com/stories/2023/01/09/2022-saw-a-historic-decline-in-vc-funding