What is Venture Capital?
Created on 13 Dec 2022
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It is a common fact that the growth of an economy depends largely on the development of its businesses. When it comes to business growth, small and medium-sized businesses can grow only if they are well-funded, at least in their initial days. This is where venture capital, a form of financing, comes into play.
Venture capital financing is one major source of financing for businesses. The drawbacks of this method of financing include a cost to equity and, occasionally, a loss of corporate control. If you are wondering "what is venture capital (VC)" and how it benefits small businesses, then you are at the right place.
What is Venture Capital or VC?
Entrepreneurs who are starting companies with the potential for long-term development are given money in the form of venture capital (VC), a sort of private equity. These investments frequently, but not always, occur in the early stages of a company's development, before the enterprise has a finished good or significant income.
Wealthy investors, investment banks, and other financial organisations that focus on identifying the most promising emerging enterprises are the typical sources of venture capital. So, “What venture is capital?” It is both a tool for funding businesses in the short term and a means of long-term wealth accumulation for affluent individuals and institutional investors.
However, venture capital support is not necessarily in the form of cash; it may also come in the form of administrative or technological know-how. Despite the fact that putting money into these young businesses might be risky for investors, the prospect of above-average returns is a tempting payout.
Venture capital funding is gradually becoming a popular and necessary source for obtaining funds for new businesses with a very brief working history, especially if they do not have access to financial markets, bank borrowings, or other debt instruments. The biggest drawback for the entrepreneurs is that this funding gives the investors a share in their business and, consequently, a voice in corporate decisions.
What is a VC Firm?
Investment companies, known as venture capital (VC) firms, support and coach start-ups and other emerging businesses. A venture capital business uses funds collected from limited partners to invest in potential private enterprises, doing just what seed funding and private equity firms do.
In contrast to private equity firms, venture capital firms frequently invest in businesses with a minority ownership position of 50% or less. Some of the prominent venture capital firms that heavily invest in Indian companies are:
- Sequoia Capital
- Saif Partners
- Nexus Venture Partners
- Matrix Partners
- Kalaari Capital
Who are Venture Capitalists?
Those who make early-stage investments in businesses with great potential are known as venture capitalists. They assist with generating money for venture funds and actively look for investment options for the business. An individual investor or a group of investors who come together through investment firms might be referred to as a venture capitalist. I know you are picturing yourself in the Shark Tank; calm down, buddy.
What is the Organisational Structure of a Venture Capital Firm?
The typical organisational form of a venture capital firm is that of a partnership fund, with the firm acting as the general partner and the investors acting as the limited (passive) partners. The latter might comprise insurance firms, pension funds, university endowment funds, and affluent individuals, among others.
Although all of the partners have ownership rights in the venture business, the general partners really take the lead. They could even act as directors, managers, or consultants for the portfolio firms they invest in.
The general and limited partners each receive a portion of the profits from the investments made in the numerous businesses. As a reward for their performance, the general partners often get around 20% of the earnings (commonly referred to as a "carry"). Without “carrying” any workload.
A management fee of up to 2% of the total invested money may also be paid to them annually. The remaining 20% of any gains are distributed equally (pro rata) to the fund's limited partners who made investments.
How Do Venture Capital Funds Operate?
Venture capitalists invest in a business up till it becomes a major stakeholder before exiting the same. In a perfect world, investors would put money in a firm for two years and receive returns for the next five. The expected return on investment might be up to 10 times that amount (again, in a perfect world).
Financial venture capital can be provided by a variety of investors, including
- Venture capital firms
- High net worth individuals (angel investors),
- Investment banks and other financial institutions.
Venture capital firms also gather investments from other investors, businesses, or funds into a common fund that is then used for investment purposes (party ke liye contri). Also, the portfolio of businesses that venture capital firms invest in often falls under a certain field of specialisation. For instance, a venture capital firm concentrating on the telecom industry would invest in a portfolio of 10 businesses developing innovative communication tools and technology.
Advantages and Disadvantages of Acquiring Venture Capital Funding
Bootstrapping the firm, which means investing money on your own, is an additional option that doesn't require giving up an interest in the company. However, it is crucial for business owners who seek venture capital investment to comprehend both its advantages and risks:
The advantages of venture funding:
1. The exponential growth of the business (pachees din me paisa double): A company can witness rapid development owing to venture capital funding, which offers a significant cash infusion to carry out the planned objectives.
2. Expert advice is available (computer ji lifeline ankit kijiye): Many venture capital firms are directly involved in managing the businesses that are part of their portfolios. They offer technical support, help develop plans, and link with the appropriate commercial contacts. Venture investors sometimes have extensive networks that may provide the business with a reliable consumer base.
3. No responsibility to pay back (nuksan hua toh aapka, faida hua toh hum sabka): If a startup fails, the entrepreneur is not required to pay back the venture capital investments they made in the business. However, because it entails stock dilution, a business owner may lose control of their organisation, the original investment, as well as the time and effort they have devoted over the years to build the firm.
Venture capital funding drawbacks:
1. Loss of equity (batvaara hoga): Promoters often loses some control over the firm as a result of a venture capital investment. When VCs own a majority share, the promoters could be given the last say on important management choices, and they might be more focused on getting their money back than on the company's long-term success. Businesses that are poised for success might wish to give the idea of taking outside funding some serious thought.
2. Conflicts of interest (commitment nahi milega): According to some venture capital arrangements, the VC company is not subject to non-compete clauses or other limitations. This implies that the company may invest in (or keep stakes in) rival businesses.
The Bottom Line
Venture financing may be a capable accelerator for risk-taking entrepreneurs with fast-growing businesses. It comes with trading funding and expertise for a part of your business's earnings and control. It obviously comes with its own bucket of pros and cons. One of the most crucial choices that you as an entrepreneur must make is whether to take the venture capital path.
Do you think you have the courage to let go of some stake in your business in exchange for the investment?
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