What is venture capital?
Venture capital is the capital provided by firms of professionals for young, rapidly growing or changing companies with high growth potential. A venture capitalist (VC) may provide capital for unproven ideas, products, technology or start-up firms. The VC may also invest where raising finance through conventional means is not possible.
How is it different from other financing?
Venture capitalists finance unproven, innovative ventures having high growth potential. It makes venture capital a high risk-high return idea. Besides finance, venture capitalists also provide managerial support for realizing the full potential of the venture.
What are the types of VCs?
Generally, there are three types of organized venture capital funds:
those set up by angel investors i.e. high net worth individual investors
subsidiaries of companies and
private venture capital firms.
Such subsidiaries are established by major companies, bank holding companies and other financial institutions. The primary institutional source of venture capital is a venture capital firm. Venture capitalists take higher risks by investing in an early-stage company with no history and expect a higher return for their equity investment.
Which areas do venture funds prefer to invest in?
Different VCs prefer different investments. Some specialize in seed capital (initial capital) and early expansion while others focus on exit financing (VCs exit when the company goes public). Biotechnology, medical services, communications, electronic components and software companies are attracting the most VC financing. In India, the software sector has been attracting a lot of venture finance. Media, health and pharmaceuticals, agri-business and retailing are the other favoured areas.
Is it easy to raise venture capital?
Getting investment from an institutional VC is extremely difficult. It is estimated that in the USA, only 5 business plans in 100 are viable opportunities out of which only 3 successful financing. In fact, the chances could be as low as 1 in 100. More than 50% of all proposals are rejected after a 20-30 minute scanning, and 25 % get discarded after a lengthier review. The rest 15 % are examined in detail, but at least 10 % are dismissed due to fatal flaws in the management team or the business plan. Another consideration is the amount of venture capital sought.
Generally, the VCs look at managerial capability, market attractiveness and cash out potential.
What type of returns is expected by VCs?
Institutional VCs look for average returns of at least 40 - 50 % for start-up funding. The second stage and later stage funding usually requires at least a 20 - 40 % return compounded per annum. Most firms ask for large portions of equity in return for start-up financing.
Many VCs end up owning substantial amounts of company equity, which sometimes gives them equity control. The professional investor examines the value of the company prior to investment and the investor's financial contribution while determining the equity necessary to get adequate return. This issue is often the largest hurdle for VCs and owners to cross.
What are incubators?
Incubators are mostly non-profit entities which provide advisory, informational and support infrastructure like productive office environment, finance and complementary resources. Incubators are mostly promoted by government or organizations trying to develop small enterprises in a particular area. A case in point is the incubator set up by the Indian Institute of Management, Ahmedabad on its campus to promote entreprenuership.
Sometimes VC funds also have their own incubators and companies also set up in-house incubators. Incubators support the entrepreneur in the pre-venture capital stage i.e. when he wants to develop the idea into a viable commercial proposition, which could be financed by a VC later.
So what does a VC look for?
A strong management team with each member having adequate skills, commitment and motivation that creates a balance among marketing, finance, and operations, research & development, general management, personnel management, and legal and tax issues.
A viable idea — establish the market for the product or service, why customers will purchase the product, who the ultimate customers are, what the competition is, and the projected industry growth. The business plan should describe briefly the nature of the business, the profile of the management team, business performance so far and business projections.