Meaning of of Venture Capital
Venture capital is type of financing provided to start-up or early staged companies expected to have high-growth potential in future. It is termed as financial tool for companies and vehicle of investment for rich individuals or institutional investors. Wealthy investors are more willing to channel their funds in start-ups venture that carries a long-term growth perspective. The capital invested in new ventures is called venture capital and the people investing funds are called venture capitalists. Venture capital help companies with low image for raising funds in short-term and for investors to grow their wealth in long term. The entrepreneurs in initial days find difficulty in accessing bank financing options mainly due to lack of business experience and high-risky nature, therefore venture capital come in for their relief. Main focus of venture capitalists is on emerging companies and these investments are quite risky due to their illiquid nature.
Venture capital investment is also termed as risk capital or patient risk capital due to inclusion of high risk in it. This type of investment carries large risk of losing money because if venture did not succeed then investor won’t be able to earn return and may even lose their invested value.
Types of Venture Capital
Venture capital funds are classified on the basis of their usage in distinct phase of business organization. These are mainly of 3 types such as early stage financing, expansion financing and acquisition financing.
- Early stage financing: Early stage financing is further sub-classified into seed financing, start-up financing and first stage financing. Seed financing is small amount given to new venture for serving motive of qualifying for start-up loan. When business acquire funds for finishing the development of its products or services then it comes under start-up financing. Whereas, first stage financing refers to capital amount required by business in order to initiates its activities in full swing.
- Expansion financing: The expansion financing is divided into 3 parts that are: – second stage financing, bridge financing and third stage financing. Both second stage and third stage financing are provided to firms so as to initiate their process of expansion in major way. The bridge financing on other hand, is offered to companies as monetary support at the time of employment of IPO (Initial Public Offerings) in the form of principal business strategy by them.
- Acquisition or buyout financing: Under acquisition type of financing, acquisition finance and leveraged buyout financing are two categories falling under it. Acquisition financing is used by company when it needs funds for acquiring some other company or parts of company. Whereas, when some other company’s specific product needs to be acquired by management group of company then leveraged buyout financing comes to aid.
Characteristics of Venture Capital
The features of venture capital are discussed in points given below: –
- Illiquid: Venture capital are illiquid by nature that can’t be converted into cash by investors on short notice. These investments do not provide short term pay-out option as compared to other publicly traded instruments in market. Venture capital investment either take the form of loans or convertible debentures and offers fixed yield to investors. Investors can avail benefit by investing their funds in such capital only in long run because the returns are completely dependent upon company’s growth.
- Riskier: These type of investment carries high amount of risk due to lot of uncertainty factor associated with new venture’s success where investment is made. Funds are provided by venture capitalist for companies that are in their early stages and are yet not well-established, therefore carries more chances of getting failed. Investors will get their expected return only if company reaches the expected growth rate in future.
- New firms financing: Venture capital is basically source of capital available for new ventures that are unable to acquire funds from capital market. New firms lack credibility and trustworthiness due to which they can’t raise capital from multiple sources unlike well-established firms. Such ventures can easily attract venture capitalists if have innovative project as well as high-growth potential.
- Management participation: The venture capitalist not only provide finance to company but also take part in its management activities via holding investment in equity capital. They imply their management expertise in handling business operations efficiently. This approach of capital investment differs from traditional bank lender or ordinary stock market as they only provide funds to company and do not participate in management activities.
- Nor for large scale industries: Venture capital investment is not ideal for large scale industries as it is expensive form of financing that bring high cost to company. The investors expect higher amount of return for undertaking risk as compared to other type of investment securities in market. However, small scale industries require small amount of funds and can therefore afford the cost of venture capital when they are unable to access other financing options.
- Long-term investment: Venture capital investment is made for longer term in companies carrying high chances of growth in future. The return form such investments can be realized by investor after around 5 to 10 years. Investment is made to support long-term growth and expansion activities of business enterprise. This type of investment is unfavourable for investors who are looking for options to benefit themselves in shorter period of time.
Disadvantages of Venture Capital
Various disadvantages of venture capital are summarized in points given below: –
- Founder ownership is reduced: The major drawback of venture capital is that entrepreneurs need to be give up their ownership stake for acquiring fund. Funding by venture capital results in dilution of founder ownership in business enterprise as such investor provide funds in return for stake in equity of company. On success of start-up businesses, venture capitalists are able to earn huge amount of profits. They also may become part of company’s board and actively participate in key decision making. In case of differences among start-ups founder and venture capitalist, things may get chaotic bringing negative consequences for business.
- Long and complicated process: Acquiring capital from venture capital institutions is long and complicated process. Initially a well drafted business plan needs to be presented by owner that gets analysed by venture capital investor. After that, one-to-one meeting take place among owner and investor for having detailed discussion regarding business plan. Now, if venture capitalist gets agree for funding then due diligence is done for verification. On founding the verification satisfactory, a term sheet is offered by VC thereby involving lengthy process of acquiring funds.
- Give rise to conflict of interest: Venture capital funding may also lead to conflicts in between venture capitalists and owner due to difference in their viewpoints. These investors not only provide funds to business but also get controlling stake in according to their financing ratio. They also chair board level meetings and other senior management meet where they equally participate in decision making. Therefore, there are chances of conflict due to disagreement on any point between investor and owner that ultimately hinder effective decision making.
- High cost of financing: Companies need to incur huge costs in order to acquire funds from venture capital institution. The investment process of venture capital is quite lengthy requiring negotiation and due diligence period. The venture capital firm for drafting necessary documents employ services of attorney during negotiation period. Once a rough deal is done, due diligence is conducted by venture capitalist on target company. It needs accounting, legal and operational assessments of firm is carried out by external professionals. All these services are expensive and need to paid up by start-up companies from their investment.
- May result in under-valuation: Venture capital investment may lead to under valuation of company bringing negative effects on its growth and productivity. Many times, the venture capitalists are in a hurry to sell of their equity stake. They may even pressurize the company’s owner for listing company in order to sell off their stake rapidly. Such untimely listing of company will under-value the company stocks ultimately bring negative consequences for the owners of company.