This article is written by Madhav Gawri, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
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Financing is done in many forms, from seed capital and putting in your own finances into a project you believed and rationalized would be profitable in the future to capital financing through the channels of the stock market. In between the process of funding, a concept of venture capital financing lies. It is a form of private equity financing that the investors provide to start-up companies or small businesses that they believe to have long-term growth and potential. People who invest their money in start-ups or small businesses are called Venture Capitalists. It can be rationalized that venture capitalists come into play during the series A funding stage and to an extent of series B funding. They buy volumes of shares of the company and become a financial or a managing partner in the business. Venture capitalists are high net-worth investors, investment banks, or any other financial institution. Venture capitalists usually put in their value in the form of monetary terms, but they can also be valuable in the form of technical or managerial expertise.
Venture Capital Firm
A venture capital firm’s purposes are to identify areas and invest in those areas that would generate heavy momentum in the future and create profits. A firm not only acts as an investor but also provides managerial support as well. A venture capital firm invests its own money as a form of commitment and assurance.
Crucial Positions in venture capital firms are:
Roles and responsibilities
Entry-level employees whose roles are decided by the firm. They usually have experience in management consulting and investment banking and may perform contract reviews, financial analysis, and valuation.
Senior-level staff who can make investment decisions but cannot make the last call. Similar to associates, their roles and responsibilities can also differ.
Principals report to venture partners (VPS).
Venture partners (VPS)
Partners of the firm who manage the regular activities. They are also responsible for sourcing different opportunities for investment and may be paid as per what they bring.
Venture partners report to general partners (GPs).
General partners (GPs)
Head of a venture capital firm. They invest their own funds in a company alongside their investors. GPs make the last call for investment decisions.
Venture Capital Funding Process
STEP 1: Idea Initiation
The first step is to create, plot, and present a well devised business plan and approach to a venture capitalist and submit the same to him. The business plan should include an executive summary of the business and its intended future. The description of the opportunity, its market, and it’s potential. Moreover, the plan should also include a detailed financial projection.
STEP 2: Introductory Presentation
After the completion of the preliminary study by the venture capitalist, the promoters present and meet with the venture capitalist to explain their vision. There is a one-on-one meeting, and the project is discussed in that meeting. After the completion of the meeting, the capitalist makes his final decision whether or not to move forward to the due diligence stage of the process.
STEP 3: Due Diligence
In this phase, the nature of business plays an important role. Focus is on solving queries related to customer references, products, business strategy, financial planning, management etc.
STEP 4: Term Sheets and Funding
The venture capitalist offers a term sheet, if the due diligence comes out to be satisfactory. A term sheet is a non-binding contract that explains the basic terms and conditions of the relationship between the capitalist, the owners, and the company’s promoters. After the competition of the legal documents and legal due diligence, funds are made available.
Top Venture Capitalists in India
The following list is not in any particular order:
- Accel Partners
- Helion Venture Partners
- Sequoia Capital India
- Nexus Venture Capital
- Blume Ventures
The above list is not exhaustive.
Pros of venture capital financing
- PROVIDE LARGE SUM OF EQUITY FINANCES: A start-up or a small business requires a large sum of money to kick their plan in the market. For this kickstart, the business requires funds and a good amount of cash flow to generate initial momentum.
- BUSINESS EXPERTISE: Apart from finances, a venture capitalist also provides expertise and managerial roles and guidance experiences. Moreover, a venture capitalist can play a vital role as a consultant to the business. The venture capitalist can help in making many decisions such as financial management and human resources.
- ADDITIONAL RESOURCES: A venture capitalist also provides guidance in critical areas such as legal, tax, and personal matters. A venture capitalist can provide better guidance while making important decisions in the course of the business.
- CONNECTIONS: Venture Capitalists are very well connected to the community. Tapping into these connections would help the business.
- VCs CAN HELP YOUR COMPANY GROW QUICKLY: Without the venture capitalist funds, the business will have to wait for a steady stream of revenue and financial stability. But with extra huge amounts of money, it would be easier to take the business to another level almost immediately.
- NO OBLIGATION TO REPAY THE MONEY: Venture Capitals are technically gambling their money in you and your business. If it succeeds, then they win big, but if it fails, they have to eat losses. And you have no legal obligations to repay the funds back to the venture capitalist. If you go under, you won’t have to repay the investor.
- HELP MANAGING RISK: The failures of a start-up in their first year is very high. But by having an experienced official can help to mitigate the risk. The official can provide correct guidance and can correctly mentor the promoters.
- NO PLEDGING OF PERSONAL ASSETS: Unlike a bank loan, raising funds from a venture capitalist doesn’t require to put personal assets as security against the funds raised. A venture capital investment in the business doesn’t lend to the business.
- INCREASED PUBLIC RELATIONS: Many venture capital firms have a public relations group and media contacts. It is in their best interest to get exposure. The increased publicity can lead to potential employees, customers, partners, and other venture capital firms’ interest in raising funding.
Cons of Venture Capital Financing
- AUTONOMY AND CONTROL OF THE FOUNDER ARE LOST: A venture capitalist provides funds to the business, and against that funds, it takes equity in the business. Therefore, this creates a dilution in the shareholding and ownership rights of the previous owners and shareholders.
- LENGTHY AND COMPLEX PROCESS: Raising funds from a venture capitalist is a tedious and time-consuming process. The venture capitalist would perform all of this due diligence on the business and on the current owners. Moreover, the capitalist would also conduct a risk study and market analysis on the business he will invest in.
- UNCERTAIN FORM OF FINANCING: Obtaining funds from a venture capitalist is very uncertain. It is not necessary that all start-ups or small businesses obtain funding from a venture capitalist. Many start-ups are rejected by the venture capitalist present in the market.
- MINORITY OWNERSHIP STATUS: The venture capital firm may only invest in the business if the owners are ready to give up 50% or more than 50% of their shareholdings in the business. Depending on the dilution of the shareholding, the owners can easily lose the business’s management control.
- THE BUSINESS MAY NOT BE READY TO GROW: If you accept funding from a venture capitalist but you haven’t figured out a way to earn profitable and steady profits and revenue, then you could end up wasting money by extra manufacturing or hiring extra personnel.
- FORMAL REPORTING STRUCTURE: When the founders accept a venture capitalist’s funding, then this creates a responsibility of accountability in the hands of the founders to the venture capitalist. The founders become answerable to the venture capitalist. Therefore, in some, it creates authority over the founders.
- BUSINESS IS EXPECTED TO SCALE & GROW RAPIDLY: After receiving the venture capitalist funds, the business is expected to grow rapidly and exponentially. If this doesn’t happen or the plan is not executed well, it can lead to diminishing growth as well. This will up tremendous pressure on the founders.
- NO LEVERAGE FOR FOUNDERS IN NEGOTIATIONS: Most start-ups and small businesses seek funding to meet their needs. In most of the negotiations, the start-ups don’t have the leverage to negotiate. They have an option to either accept the deal or reject the deal.
- Whether the founders are ready to accept a more active and inclusive role of the venture capitalist?
- Whether inputs and expertise of the venture capitalist would be appreciated apart from the financial assistance?
- Is loss of ownership and control being an issue for you?
- Whether you would be able to gain from the connections of the venture capitalist?
Even with many cons attached to the concept of raising funds from a venture capitalist, it still remains one of the top sources of raising funds for start-ups and small businesses. But considering the risk and the negatives attached to it, there are many positives as well attached to it. Therefore, one should always make a considerate and well thought decision before accepting capital from the venture capitalist.
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