Venture capital (VC) is an important part of a startup ecosystem because it can offer capital that innovative businesses need to develop. However, has it ever crossed your mind how venture capital firms are able to avail funds? In this blog, we will get to know how venture capital companies accomplish the process of fundraising, investment management, and development of a startup.
What is Venture Capital?
Venture capital is a form of private equity given to start-up companies, which are of high potential. Venture capital firms provide a company with capital in exchange for equity rights or ownership of the startup. Such investments are risky, but they can yield huge returns in case of a successful startup.
Sources of Funding for Venture Capital Firms
Venture capitalists do not apply their capital to startups. Instead, they take loans from outside investors. This type of investor is also referred to as the Limited Partners (LPs), which have a mixture of sources:
1. Institutional Investors
These are the largest suppliers of venture capital funds. They include:
- Pension funds
- Insurance companies
- University endowments
- Sovereign wealth funds
Investors, in their effort to minimize risk and to seek high returns, venture capital is represented in the portfolios held by institutional investors in just a small percentage.
2. HNWIs (High-Net-Worth Individuals)
Very wealthy people usually invest in venture capital as private investments. They have an eye on the possibility of large returns and enjoy the excitement of funding new and exciting discoveries.
3. Family Offices
A family office is a wealthy family servicing a wealth Management Company. These offices tend to buy venture capital as a way of getting access to exclusive opportunities for startups.
4. Corporations
Corporate venture capital is also known as CVC, where large companies, particularly large technology companies, invest in startups. These investments are strategic as well as financial, so that the company can be ahead of the game in terms of innovation.
5. Fund of Funds (FoF)
This is the type of investment fund that invests in many venture capital funds and not directly in startups. They want to have a wide scope of investments in various industries and management.
Venture Capital Fund Structure
Venture capital companies work on a fund basis. That is how it works:
1. Fundraising Phase
Venture capital firms make a pitch to the LPs and collect a pool of money (commitment) which gets locked in for a period (generally 10 years). The company establishes an attractive amount of the fund and exposes its investment strategy.
2. Capital Commitment
LPs agree to make an agreed-upon amount of money towards the fund. But, it is not the case that all the capital is transferred at once. Rather, it is depleted as occasioned when there is investment by the VC firm.
3. Management Fee and Carried Interest
There are two ways through which VC firms make money:
- Management Fee: A standard fee is 2 percent of the capital over which the entity is set to make a given commitment each year. This includes running costs.
- Carried Interest: Usually 20 percent of the gains on exits of a start-up company, as capital is returned to LPs.
How VC Funds and Start-ups Invest in Startups
After the capital is raised, the VC firm then goes ahead to find startups with high growth potential via an intense due diligence process. They assess the startup of:
- Business model
- Founding team
- Potential market
- Technology
- Competitive advantage
VCs will mostly be active investors who provide industry mentorship and strategic advice and assist with future fundraising.
Venture Capital Stages of Startup Funding
The venture capital financing tends to be in phases:
- Seed Stage: Finance to build a business idea
- Series A: Money to expand the business and recruit talent
- Series B, C, and Beyond: This is considered the growth stage, where funding normally precedes an IPO or buy-up
There are different stages with a corresponding growth in investment and valuation.
Returns and Exit Strategies
Venture capitalists use exit strategies in order to recover and increase their capital investments in:
- Initial Public Offering (IPO)
- Acquisition or Merger
- Secondary Sale
These windows provide VCs with the opportunity to reinvest their earnings with their LPs and bill them their carried interest.
Conclusion
The venture capital firms can be considered as a strong source of innovation as they provide start-ups with the necessary funding at a decisive, critical moment. They gather capital through institutional investors, high-net-worth individuals, and others to develop extensive VC funds. These funds are invested prudently in young companies that have great growth opportunities. The way venture capital funds start-ups is little understood, but by relatively simplifying the process, one sees the intricate web of people who are known but are behind the scenes, making it possible to fill the next big thing.
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