Embarking in an entrepreneurial process is motivating and captivating, but hopes and dreams can vanish if there is no financial backing. However, in some cases venture capital funding can provide motivated entrepreneurs with viable ideas a financial rescue.
Venture capital (VC) refers to money offered by external investors to fund new or existing businesses. Venture capitalists provide funds bearing in mind the company face risks for its future profits and cash flow. Venture capitalist invest in firms in exchange for a stake in equity rather than give out funds as a loan. This form of funding provide an essential source of financing for startup businesses and other ventures with limited operation history and have limited access to capital markets.
Some excellent alternatives to venture capital exist that entrepreneurs need to consider. An ‘Angel investor‘ is one such alternative. This investor takes the entrepreneur under his or her wings and takes the idea to the next growth level. A strategic investment partner is another consideration. These partners could be vendors, customers, or other business partners currently working with you or may be interested in investing in your firm. Strategic investors often possess deeper pockets than angel do but characteristically have a particular reason for investing in your company. It is your responsibility to ensure you know the reason.
How Venture Capital Funds Operate
Venture capital funds are considered for either seed, early or expansion stage financing. This depends on the maturity of the firm at the investment period. Like other funds, venture capitalists must raise funds before to making any investments. A prospectus is issued to potential investors willing to commit funds to the fund. The fund’s managers call all prospective investors who make an obligation, and individual investment amounts finalized.
The following step involves venture capitalists seeking private equity investments with the capacity to generate positive proceeds for its investors. This process implies that the manager(s) of the fund reviews numerous business plans while evaluating potentially high-growth ventures. Investment decisions are based on the prospectus and expectations of the investors. Once an investment is made, an annual fee of about 2% is charged for managerial services.
How do Venture Capitalists Make money? Venture capital fund investors make gains when a portfolio company exits. The exit may be through an IPO, merger, or acquisition. When profit is made through an exit, the fund retains a percentage in addition to the annual management fee.
The Funding Process
Phase 1: Submitting a Business Plan
The first thing when approaching VCs is the submission of a business plan. A business plan should at least cover the following:
• A description of the company and the product
• A description of the target market and its size
• Resumes of the management team
• A review of the business environment regarding competition
• A detailed financial projection
• A capitalization table.
A business plan and an executive summary are together for evaluation by the VCs.
Phase 2: Introductory Conversation
This involves a meeting with the managers of the fund if the firm has potential to generate income and they prefer to invest in it. After this session, the VC determines whether to move on to the next step.
Phase 3: Due Diligence
This phase depends on the nature of the submitted proposal. The process takes approximately three weeks to three months where you expect multiple calls as well as interviews.
Phase 4: Term Sheets and Funding
Once a VC is satisfied with due diligence, a term sheet is issued. A term sheet is a non-binding document outlining the terms and conditions of the contract. This document is negotiable, and all parties must agree to its terms.
The Funding Process
Series A investors usually refer to the first professional investor you get into the contract. Series B, C, and D follow up the initial deal in the later stages of the investment. The last rounds of funds include mezzanine, late-stage, and funding prior to IPO. Venture capitalists may provide funds for one of these stages or decide to support the entire process. It is advisable that you find out the preferences of the investors.
i. Seed Capital. Startups with no product or company seek this form of funding. Few venture capitalists provide funding at this level. Funds obtained at this stage are used to design a model product, fund market research, and cater for administrative set-up expenses.
ii. Startup Capital. Now, the company has at least a sample product available and one principal working throughout. As in step one, it is also rare to find VCs to fund this stage. Funds at this level usually cover recruitment, further market research, and refining the service or product for market introduction.
iii. Early Stage Capital. This comes when the company is in the second or third year of operation. At this level, the company is running, active management is in place, and sales are rising. VC funding at this level could help in increasing sales to the break-even point and improving productivity as well as increasing efficiency in the company.
iv. Expansion Capital. More VCs may be available at this stage. Funding at this level is needed to take the company the next level. Funds may assist in entering new markets and increasing marketing efforts.
v. Late Stage Capital. At this stage, the company has accomplished remarkable sales and returns and a second level management is in place. Funds at this level may be used to boost capacity, ramp up promotion, or add to working capital. Consideration for a merger or acquisition partner takes place at this stage. The majority of the VCs cover funding at this spectrum by specializing in IPOs, buyouts and recapitalizations.
What do Venture Capitalists look for?
Venture capitalists search for ventures with the potential to grow rapidly to a noteworthy size, yielding a considerable gain on their investment in a comparatively short period. VCs are more interested in the future growth prospects of the company than its current size. Although there are no set determinants for a successful portfolio company, most VCs tend to evaluate the following factors.
i. Commercial viability
The consideration here is to evaluate whether the company has a product or service that can be reproduced efficiently to make returns. Products that promise more revenue generation shortly are more of interest to the VCs.
ii. Identifiable market
The consideration is to evaluate if the company has a clearly defined market for its products or services. If yes, does product or service meet the identified need?
iii. Active management
Does the management of the company inspire confidence? Do they possess the vision, skills, and the aptitude to drive business to a serious level?
iv. Sustainable competitive advantage
The company’s product is considered concerning its uniqueness and capacity to inhibit others from encroaching its market. The company is evaluated considering economic and technological changes that might affect its model. Who are the potential investors and competitors and their weaknesses and strengths?
1. Venture capital funding is one of the options for entrepreneurs to secure funding.
2. Although there are alternatives, VCs are essential for advanced financing in business.
3. VCs evaluate several factors before committing funds to an investment.
Sylvester Kaczmarek is an award-winning entrepreneur and product manager with over a decade of international, quality-driven IT industry experience.