Venture Capital

VENTURE CAPITAL

Venture capital is financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks and any other financial institutions. However, it does not always take a monetary form; it can also be provided in the form of technical or managerial expertise.
Though it can be risky for investors who put up funds, the potential for above-average returns is an attractive payoff. For new companies or ventures that have a limited operating history (under two years), venture capital funding is increasingly becoming a popular – even essential – source for raising capital, especially if they lack access to capital markets, bank loans or other debt instruments. The main downside is that the investors usually get equity in the company, and, thus, a say in company decisions.
Features of Venture Capital investments

  • High Risk
  • Lack of Liquidity
  • Long term horizon
  • Equity participation and capital gains
  • Venture capital investments are made in innovative projects
  • Suppliers of venture capital participate in the management of the company

Methods of Venture capital financing
  • Equity
  • participating debentures
  • conditional loan

The venture capital funding process typically involves four phases in the company’s development:
  • Idea generation
  • Start-up
  • Ramp up
  • Exit

Step 1: Idea generation and submission of the Business Plan
The initial step in approaching a Venture Capital is to submit a business plan. The plan should include the below points:

  • There should be an executive summary of the business proposal
  • Description of the opportunity and the market potential and size
  • Review on the existing and expected competitive scenario
  • Detailed financial projections
  • Details of the management of the company
There is detailed analysis done of the submitted plan, by the Venture Capital to decide whether to take up the project or no.

Step 2: Introductory Meeting
Once the preliminary study is done by the VC and they find the project as per their preferences, there is a one-to-one meeting that is called for discussing the project in detail. After the meeting the VC finally decides whether or not to move forward to the due diligence stage of the process.

Step 3: Due Diligence
The due diligence phase varies depending upon the nature of the business proposal. This process involves solving of queries related to customer references, product and business strategy evaluations, management interviews, and other such exchanges of information during this time period.

Step 4: Term Sheets and Funding
If the due diligence phase is satisfactory, the VC offers a term sheet, which is a non-binding document explaining the basic terms and conditions of the investment agreement. The term sheet is generally negotiable and must be agreed upon by all parties, after which on completion of legal documents and legal due diligence, funds are made available.

Exit route
There are various exit options for Venture Capital to cash out their investment:

  1. IPO
  2. Promoter buyback
  3. Mergers and Acquisitions
  4. Sale to other strategic investor

Five Stages in Venture Capital Financing
There are five stages in venture capital financing, and they include:
  1. Seed Stage
    At the seed stage, the company is only an idea for a product or service, and the entrepreneur must convince the venture capitalist that their idea is a viable investment opportunity. If the business shows potential for growth, the investor will provide funding to finance early product or service development, market research, business plan development, and setting up a management team. Seed-stage venture capitalists participate in other investment rounds alongside other investors.
  2. Start-up Stage
    Start-up stage requires a significant cash infusion to help in advertising and marketing of new product or services to new customers. At this stage, the company has completed market research, has a business plan in place, and a prototype of their products to show investors. The company brings in other investors at this stage to provide additional financing.
  3. First Stage
    The company is now ready to go into actual manufacturing and sales, and this requires a higher amount of capital than the previous stages. Most first-stage businesses are generally young and have a commercially viable product or service.
  4. Expansion Stage
    The business has already started selling its products or services and needs additional capital to support the demand. It requires this funding to support market expansion and start another line of business. The funding may also be used for product improvement and plant expansion.
  5. Bridge Stage
    The bridge stage represents the transition to a public company. The business has reached maturity, and it requires financing to support acquisitions, mergers, and IPOs. The venture capitalist can exit the company at this stage, sell off his shares, and earn a huge return on his investments in the company. The exit of the venture capitalist allows other investors to come in, hoping to gain from the IPO.
Returns for a Venture Capital
Venture funds will be able to realize gains only when there is a liquidity event (that is “exit”), This happens in three situations namely:
  1. Share Purchase:
    This happens when a new investor looking to buy ownership in the company buys the stake from existing Investor. Sometimes the owner of the company would also repurchase the stock.
  2. Strategic Acquisition:
    Strategic acquisition happens by way of a merger or an acquisition. This is done by a company willing to buy a differentiated technology, a large customer base, a rockstar team, or some other combinations. Example Hotmail acquisition by Microsoft
  3. Initial Public Offerings (IPO):
    Companies with a standalone business and in profits with the stable customer base, product strategy and growth would prefer raising money for future growth by IPO.

Types

The various types of venture capital are classified as per their applications at various stages of a business. The three principal types of venture capital are early stage financing, expansion financing and acquisition/buyout financing. The venture capital funding procedure gets complete in six stages of financing corresponding to the periods of a company’s development

  1. Seed money:
    Low level financing for proving and fructifying a new idea
  2. Start-up:
    New firms needing funds for expenses related with marketingand product development
  3. First-Round:
    Manufacturing and early sales funding
  4. Second-Round:
    Operational capital given for early stage companies which are selling products, but not returning a profit
  5. Third-Round:
    Also known as Mezzanine financing, this is the money for expanding a newly beneficial company
  6. Fourth-Round:
    Also, calledbridge financing, 4th round is proposed for financing the "going public" process

Advantages

  1. They bring wealth and expertise to the company
  2. Large sum of equity finance can be provided
  3. The business does not stand the obligation to repay the money
  4. In addition to capital, it provides valuable information, resources, technical assistance to make a business successful

FAQ's

Venture capitalists are individuals or companies who provide investment capital and management expertise to new businesses. In return, they will ask for an equity position in the company, usually in proportion to their risk and the amount of their investment. They have a stake in your company because their future returns are tied to its performance.

Venture capitalists effectively buy their way into the company with their investment. That means that the company will not have to repay the capital; rather, venture capitalists expect to take their return in capital gains. The company will have a sizeable amount of money to work with, while the venture capitalist takes an active role in managing the company to ensure it success. After all, the venture capitalist has just bet a great deal of money that your company will be a winner.

A venture capitalist must be seen as a partner. His or her active management participation may occur through membership on the board of directors, or through input into other management decisions. The venture capitalist's goal is a high (30-40 percent per year) return on the investment over the period of his or her involvement, which is typically four to seven years. This means that the company must follow an aggressive growth strategy.

The resources and expertise of a venture capitalist not only bring money without the requirement of regular repayment by the company, but also provide several other less tangible benefits. The venture capitalist shares a common desire for success with you, and should not be thought of as a lender. He or she contributes expertise, experience, contacts, and discipline. The presence of a venture capitalist also lends credibility to the company.

A venture capitalist typically has a preferred industry, region of the country, investment size, and stage in a company's development. Attorneys and accountants can often refer you to venture capitalists they know or have worked with. Extensive information about individual venture capitalists is also available on-line. Once you find several candidates, it is advisable to research them thoroughly, including their past performance record and any referrals and recommendations from past clients.

Ideally, your first meeting with a venture capitalist should occur after you have been introduced by a mutual contact that can vouch for you and your company. This referral can enhance your company's credibility, and your chances. You will need to make your proposal at this meeting, so you should consider carefully what you will say, and rehearse it. You will need to impress the venture capitalist that he or she can help your company grow, and that it can make money for him or her as well as for itself.

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