What is Venture Capital Investment?

UTC by Osaemezu Ogwu · 12 min read
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Photo: Depositphotos
Photo: Depositphotos

Even if the company is still a concept, venture capital investment can blossom it into reality. Here’s a guide on VC investment and how to use it to your advantage.

Investments in startups that can potentially grow in the long run are called venture capital (VC) investments. In this case, funds are either issued to small companies that can potentially grow exponentially or established companies with a high potential for further expansion.

Accordingly, VC has become a common way for companies to generate funds. It becomes a good alternative when there is difficulty in accessing loans, capital markets, amongst others. For this reason, venture capital has evolved significantly to an industry with investors looking to encourage innovation.

In line with that, this method of financing is suitable to fund companies that need a large capital to achieve their goal. This is because cheaper alternatives may be unable to make up for this upfront capital, hence, it could make or mar the business’s growth.

On the other hand, VC investment is made by wealthy individuals, banks, etc. in the form of money or technical skills. Investors known as venture capitalists (VCs) have equity in the company they have invested in, hence, they can also make decisions that will influence its operations. Likewise, there are high returns that could be gotten from these investments but investors would be posing risks to themselves from investments of this nature.

Operation of Venture Capital

Venture capital operates by creating large shares in a company and selling these shares to investors using stand-alone limited partnerships. These partnerships are created by VC firms and the partnerships are sometimes made up of similar enterprises.

Venture capital may sound similar to private equity (PE) but there is a significant difference between both. In this case, the funds from venture capital are targeted at startups that are sourcing for large funds for the first time. Contrastingly, funds raised in private equity are channeled to more renowned companies that are out to get equity infusion. PE may also provide a way for the founders of the company to transfer some of their shares to investors.

Regulatory Innovations

The popularity of venture capital is partly due to regulatory innovations. In 1958, the Small Business Investment Act (SBIC) was modified. This change brought about more flexible taxes for investors which helped to boost the VC ecosystem. Likewise, a modification to the Revenue Act in 1978 reduced the capital gains tax significantly.

Characteristics of VC Investment

Some characteristics of VC investments include:

  • Liquidity is low
  • Level of risk is high
  • Long-term investment
  • Investments are targeted at innovative projects

Pros of VC Investments

The benefits of VC investments include:

  • Enables the company to generate wealth
  • Businesses are not indebted to repay funds
  • Makes room for the provision of large equity finance
  • Provides capital, useful information, technical skills, etc. to the company

Cons of VC Investments

The disadvantages of VC investments are not limited to:

  • VC funding is a complex process
  • Returns are garnered after years of investment
  • The investment comes with some level of uncertainty
  • Founders may lose more control of the company with more investors onboard

Types of Venture Capital Investors

Various venture capital investors exist and some of these are:

Angel Investor

This is a wealthy individual who invests in startups. The investor exchanges their money for equity. Also, angel investors must be approved, even though it is not a major requirement. Accredited investors are classified by the SEC as individuals whose net worth is up to $1 million or over. These can also be investors that have raised an income of at least $200,000 in the past two years.

On the other hand, angel investors can invest while the company is just a conceivable idea or after it has begun to grow. To that effect, VC is a risky investment, which is why investors may lookout for a company that has the potential to yield a profit of at least 25%.

There are several types of angel investors and the best practice is for companies to go for a combination of each of these investors. The basic types include:

Family/Friends

These are capital provided to the company by their family or friends as a form of support. As such, the investor has a good idea of the company owner or entrepreneur to be funded. It can also be said that investments of this nature are based on personal relationships or emotions, thus, it is important for each investor to be fully aware of what they’re getting themselves into to curb losses. The downside here is that family and friends may later make an input to the company’s operation which may impact its growth negatively.

Relationship Investor

The relationship investor could be a friend of the business or a former worker. Generally, these are investors who may vouch for the business’ credibility and its potential to grow. In this case, this investor may share experiences of what they had gained from working with the company, with potential investors. For this reason, it could help to find and encourage prospects. Nonetheless, this investor does not add significant value to the business after its first stages of financing.

The Once Removed Investor

There’s the once removed investor that may be encouraged to invest in the company by someone they know personally or a domain investor. Accordingly, these investors may not know the entrepreneur or their business idea. Hence, they’ll be trusting the referee to direct them to a good company to invest in. Nevertheless, once removed investors will like to see angel investors in the company before taking the bold step to invest as well.

Domain Investor

Domain investors have good knowledge of a particular industry the company is tailored to. These investors may be executives who have spent a greater part of their career focusing on the niche or have retired from a similar niche. What’s more, they may have had academic training in that field. Accordingly, a domain investor may help to attract future investors since it gives more credibility to the company. The downside is that this investor may always want to share advice even those that are uncalled for.

Archangel Investor

These investors have a record of making successful investments. They often form a venture capital community and can add great capital to the company or entrepreneur. Much more, they may help other investors to earn by also becoming angel investors. However, archangels may be occupied with other investments and could be less involved in the company compared to other angel investors.

Venture Capital Firms

Venture capital firms are also investors in this type of funding. The National Venture Capital Association (NVCA), for instance, has several firms that make an investment in companies and organizations with an expectation of great returns. Businesses that seek funds from either these firms or individual investors are required to present a business plan. The recipient will then investigate the company’s business model, products, history, etc. before an investment is made.

General and limited partners are terms associated with venture capital funds. The general partners make decisions pertaining to investment. These partners source for startups and come to an agreement with them. They also work alongside these companies to help them achieve set goals. On the contrary, limited partners sum up the people, firms, etc. that provide the funds needed to make the investment.

VC Investing Rounds

Startups and renowned companies use different types of investing rounds to source for funds from investors. These investment stages are:

Pre-seed Round

Pre-seed funding occurs even before the seed funding round. Here, the founding team may receive funds to complete certain milestones prior to when seed funding begins. And the funds can help to employ workers that will develop a prototype. The funding amount in this stage is usually less than a million dollars, hence, the amount is usually very low.

Seed Funding Round

Seed funding is aimed at growing a business, and it can be likened to planting a seed that would one day blossom into a tree. Therefore, the funds raised through this stage will enable the company to finance certain projects such as marketing, further research, etc.

In addition, investors in this round may include family, founding team, VC firms, etc. What’s more, the funds raised in this stage may vary, but it usually ranges between $10,000 to $2 million. Also, a good number of companies that raise money in this stage have a valuation between $3 to $6 million. It is also possible for these companies not to move on to Series A round.

Series A

A company that has generated large revenue consistently gained a significant user base and met other performance indicators that can source more funds to expand its user base as well as product offerings. The company may take advantage of Series A funding where around $2 million to $15 million may be raised. The amount may also differ depending on the industry. In 2019, for instance, the average Series A funding was $12.5 million.

On the other hand, Series A funding often requires that companies plan on developing their business model in a bid to yield profit in the long term. There are cases where startups may have great ideas to generate large funds from investors. However, there’s still the potential for the company not to yield significant returns later on.

Therefore, investors in a Series A round are not only out to find companies with remarkable ideas. They need enterprises with a good strategy to turn the concepts into reality and even make huge returns. Accordingly, firms that partake in a Series A round may need to have a valuation of $22 million before garnering investors’ interest. Over and above that, once companies get their first investors in this round, it becomes easier to attract more investors.

Series B

Series B funding helps to advance companies from the development phase. These are companies that have undergone the seed stage and Series A funding, and as such, they have a large user base already. Through the help of investors, these companies can have more exposure to the market and meet the high-level demand.

What’s more, the average funds raised during this stage is around $32 million. And companies that organize a Series B funding have valuations around $30 million to $60 million. As such, these are well-established companies. That aside, this round can be likened to the Series A funding where investors may be more likely to participate after the company has garnered its first investor.

Series C

Series C funding round involves successful companies looking for more funds. The funds can help them to create new products, gain exposure to more markets, and also purchase new companies. These funds can also assist the company to scale and even grow faster. To that effect, the purchase of another company can help to scale the acquirer.

Accordingly, investors in a Series C funding stage are out to get significant profit from investing in already made companies. Some investors in this round are PE firms, hedge funds, banks, etc. Each of these would be out to invest large capital with the confidence that they can get more returns from investing in an already established company.

Asides from this stage, there are companies that may forge on to the Series D or E stages. Companies that advance to these stages may do so with the aim of running an IPO in the near future. Hence, they’ll need to increase their valuation.

IPO

A company that has gone through most of the investing rounds and has increased its valuation can proceed to launch an IPO. Here, the company goes public after its product has gained significant traction. There’s also the Post-IPO period which occurs after the company’s IPO.

There are also various types of post-IPOs: a post-IPO equity round is an investment in a company after its IPO. A post-IPO debt round is funds lent to a company after its IPO. This round can be compared to debt financing where a company is mandated to pay the lent amount and its interest. A post-IPO secondary round is an investor’s purchase of stocks from shareholders in the company, instead of the company directly. This round takes place after the company has launched an IPO.

Forms of the Venture Capital Investment

There are different forms in which venture capitalists or angel investors make investments in a company. Some forms are:

Convertible Note

Here, the company sends a note to potential investors, and the note can be converted to the company’s stock in the next financing round. Specifically, investors can ask to turn their note into the company’s stock which will be issued in the next financing round. This conversion may also be at a discount. What’s more, the note itself often contains the maturity date as well as interest. However, the company’s valuation may not be set during the time.

Simple Agreement for Future Equity (SAFE)

SAFE is meant to serve as a substitute for convertible notes. SAFE differs from notes since they are not a tool that can be used to obtain capital. Much more, SAFE neither has a maturity nor does it indicate interest.

An investor in SAFE would have to invest money in the company the money will become stocks in the next financing round. It is also worth noting that SAFEs bear similar characteristics of notes. This is because they are convertible at a discount. On the other hand, institutional investors may tend not to invest in SAFEs, even though this form of investment may be useful for companies in their early stages.

Using a Convertible Preferred Stock Investment

Another form of venture capital investment is through the use of convertible preferred stock investment. This investment would feature preferences, rights, etc., defined in the company’s financial documents. In this case, investors would have more preference than common shareholders when it comes to selling the company.

Over and above that, it is possible to convert preferred stock to common stock of the company. Companies can also issue stock options to potential employees and at a reduced price compared to what investors will have to pay.

Conclusion

Venture capital financings can help startups to raise funds that will help to promote their growth. These funds can be raised in different stages of investing round and from a wide range of investors. In the end, it is even more important for companies to understand the concept of venture capital investment in order to run a more successful round of financing. And most importantly, make the most of the funds to foster growth within a short time.

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