Do you need a venture capitalist to finance your business? In this article, we explore the ramifications of the role of venture capitalists in business financing.
New businesses are often volatile due to their risky and cost-intensive nature. As a result, they require external capital to mitigate the risk of failure. Once a new business has developed a product, it would need additional capital to scale up production and boost sales before it can expand and become self-funding. Also, business founders at the earliest stage of business development may require access to pre-seed funding in order to turn their business ideas into actual business models. One way of securing such external funding for a business is through Venture Capital.
Venture Capital (VC) involves providing start-up companies and small businesses with finance in the form of private equity. It is a great source of finance for businesses especially start-ups and small and medium enterprises. With VC financing, a private investor or a pool of investors known as Venture Capitalists provide funding for the business in return for an agreed percentage stake in the business.
A business can also get VC from investment banks and other financial institutions.
Who is a venture capitalist?
A venture capitalist is a private equity investor, who provides capital to companies with the potential for exponential growth in exchange for an equity stake in the business. Venture capitalists (VCs) take on the risk of providing capital for the business because they see the possibility of the business yielding above-average returns on investment. This is what attracts the venture capitalist to finance the business despite the high risk of uncertainty associated with new and nascent businesses. In addition to offering business support through capital financing, VCs can also offer technological or managerial expertise in the form of business advice since they are usually professionals or successful entrepreneurs themselves and are able to leverage on their business knowledge and professional networks to help grow a new company.
A venture capitalist can fund a business individually or in partnership with two or more VCs. Alternatively, these VCs may form a venture capital firm (VC firm). This VC firm is often comprised of wealthy individuals, insurance companies, pension funds, and investment banks that collectively pool money together in a fund to be controlled by the VC firm. Over the years, the VC industry has grown to include a mix of players. Institutional investors and profitable companies have begun to pool money in venture funds. For example, tech companies like Google and Intel have created separate venture funds to invest in emerging technology.1
How does the venture capital process work?
The venture capital landscape has four main players namely; entreprenuers who seek funding, investors who want high returns, investment bankers who need companies to sell, and the VCs who make money for themselves by creating a market for the other three players. These four players each have a role to play in boosting the VC industry. VCs help new companies grow by providing funds for innovation which may be difficult to obtain from traditional banks since these banks will only finance businesses that are able to secure their debts with hard assets. While, investment bankers help the VCs to sell off the companies when they are ripe for sale.
VC firms are typically formed as limited partnerships with the partners being the investors of the VC fund. The VC firm is the general partner and controls how the fund is invested. While, the other members of the fund are limited partners.
In order to fund a new company, the VC firm usually sets up a committee which is tasked with making investment decisions.
The first step in the process often involves the proposed company submitting a business plan to the VC firm. If the VC firm is interested in the proposal, the VC firm would typically perform due-dilligence on the proposed company. The due- dilligence often entails a thorough investigation of the company’s business model, products, transaction history, management style, overall financial health, and a scrutiny of the legal aspects of the business to mitigate potential risks. The VC firm may also conduct market surveys to ascertain the competitive landscape of the business. This is an important step because VC firms are usually looking to invest in companies with an efficient management team, a large potential market, and a product or service with a strong competitive advantage.
Once the VC firm has completed its due diligence, it would make a pledge of an investment of capital in exchange for equity in the company. Generally, the VC firm does not provide all the funds at once. Instead, the funds are broken down and given at different stages of the business process.
After the disbursement of the initial funds to the business, the VC firm takes an active role in the funded business by advising and monitoring its progress before releasing additional funds.
Notably, the above mentioned steps would also apply if the emerging company is to be funded by a single venture capitalist.
Do venture capitalists become part of the business owners?
The overall objective of investing in a company by VCs is to secure a sizable equity stake in the business often in the form of convertible preferred equity which is offered to the VCs in exchange for their capital. This type of equity entitles the VCs to cash flow rights and ownership stake in the company and automatically makes them part of the business owners. However, it does not mean that they have complete control over the business decisions. What it actually means in effect is that, the extent of control the VCs would have over the business and business decisions would be directly proportional to the size of their stake in the business.
If the VCs stake in the business is more than 50 percent, then there is a strong chance that the original business founders could lose control and management of the business to the VCs. Essentially, the higher the capital received by the business, the higher the VCs stake and control of the business. This presents a major disadvantage since the business owners could be pressured to sell off the business quickly before it reaches its maximum growth capacity in order for the VCs to make a fast return on their investment. That is, rather than encourage the company to pursue long-term growth, VCs may pressure the company to exit its investments. VCs wish to sell off their stake in the company quickly because even though they may receive some return through dividends, their primary return on investment is obtained from their capital gain when they eventually sell off their shares in the company which usually occurs between three to seven years after the initial investment.
How do venture capitalists exit the business?
VCs engage in venture capital financing with the ultimate goal of exiting the business at a future date. It is for this purpose that they take steps to define a clear exit strategy at the onset of the business relationship by inserting terms of dissolution in the business agreements.
Accordingly, there are primarily five exit options considered by VCs2:
Initial Public Offering (IPO): If the business is successful, the company will, through a stock market listing, offer its shares to the public so the VCs can sell off their shares in the open market at a premium.
Acquisition: The company’s portfolio may be sold to another existing firm.
Repurchase (Management buy-out): The VCs can opt to sell their shares back to the business founders.
Refinancing (Secondary sale): The VCs sell their stake to a different VC firm or other institutional investor.
Liquidation: If the business is unsuccessful, the VCs may elect to liquidate the company’s assets to recover as much capital as possible.
What documents are needed for venture capital financing?
Generally, for business transactions, a company may be required to provide documents that show compliance with applicable laws. For example, certificate of incorporation, tax certificate, articles and memorandum of association, etc.
In addition to these documents, a business may need to execute some other legal documents with the VCs to secure their financing. Some of such documents are:
Stock Purchase Agreement: It stipulates the conditions related to the sale of the company’s stock.
Investor Rights Agreement: It encapsulates the rights and priviledges afforded to shareholders.
Right of first refusal/co-sale agreement: This agreement affords the business founders or investors the first opportunity to purchase the company’s shares before they are issued publicly.
Term Sheet: A term sheet details the terms upon which an investor is willing to invest. It may cover matters like the size of the investment, financial instruments that may be utilised, the company valuation, liquidation, financial struture, etc.
Conclusion
VCs are willing to risk investing in nascent companies because they earn a massive return on their investments if the companies become successful. However, there are instances where VCs also experience high rates of failure due to the uncertainty associated with growing a new business. Most importantly, VCs boost entrepreneurship by creating an alternative source of business finance that do not require hard assets which are difficult for start-ups to provide.
Reference List:
- Hayes, A. (2023) What is VC and How Does it Work? Investopedia. <https://investopedia.com/terms/v/venturecapital.asp> ↩︎
- Schwienbacher, A. (2009) Venture Capital Exits. ResearchGate.
DOI:https://doi.org/10:12002/9781118266908.ch18.x ↩︎
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