Meaning of Venture Capital Financing
Venture capital financing refers to the funding of capital by venture capital firms to startups, early-stage, and emerging companies that have high potentials for growth in the future. The investment is made in startup companies involving a high degree of risk in return for an ownership stake or for equity. People funding such businesses are called venture capitalists, who make investments with a view to making better returns once the company becomes a success. These peoples are of high net worth which possesses the ability to bear large losses by funding unproven and high-risk companies. The main factors considered by venture capitalists while choosing companies for doing investment like growth potential of the company, uniqueness of its goods and services, and strength of management team.
Venture capital financing serve as a key source to raise required capital for entrepreneurs with minimal operating history and inadequate funds for successful launch of their business. In addition to securing capital, the entrepreneurs are able to get opinions and guidance form experienced business executives.
Methods of Venture Capital Financing
Various methods of venture capital financing are as discussed in points given below: –
Equity financing is a fund-raising method used by start-up companies who are in need of a large amount of capital, having a robust business plan and better chances of high potential future growth. These firms are new to the market with irregular income in the beginning phase due to which they are not able to give timely returns to investors. Under such conditions, the equity financing method proves to be the most beneficial method for start-up businesses. Companies raise funds from investors and in return provide them a stake in their business. The overall contribution of investors is not more than 49% such that they do not have voting rights. Entrepreneurs have full power to make critical decisions and run the business venture.
The debenture is another common method used by start-up firms for acquiring the required amount of funds. It denotes a guarantee given by the company to fund providers for repayment of their money once the security gets matured. The company issues a debt paper to investors which act as an acknowledgment slip in order to raise funds for a specific time period. The interest is paid by the firm on debentures on distinct rates which varies as per the phase of their operations: –
- Before business commencement phase- Nil
- After business commencement phase- Low interest rate
- Phase after a particular level of operations- High interest rate
Conditional loans are different from bank loans which do not carry any fixed rate of interest nor any pre-determined schedule of payment. Here, under these types of loans, the entrepreneur pays the lender in the form of royalty once the venture starts generating revenue. There is no payment of interest on the loan amount to the lender. The royalty rate may be in the range of 2% to 15% which varies due to factors such as external risks, gestation period, and patterns of cash flow.
Conventional loans are unlike conditional loans, where the entrepreneurs are required to pay interest to lenders. During the initial days, the interest paid is at a lower rate which increases with the rise in profit earned by the venture. Also, in addition to interest paid on borrowed capital, a royalty is also paid by an entrepreneur in accordance with profit/sales.
Income notes are a hybrid form of financing available for business ventures. It combines the features of both conditional loans and traditional loans from banks or NBFCs. The entrepreneur pays interest and is required to repay the principal amount within the predetermined period of time. The royalty amount is also paid by the entrepreneur on sales volume or profit.