FEATURE > Venture Capital

What is Venture Capital?
 
Your startup is growing. You finally have cash flow. Time to enjoy? Not if you raised venture capital. "There are certain strings attached to VC money," Kanwal Singh, Helion, explained.

Venture capital is the term for money invested in young, fast growing companies. Many of today's leading companies were backed by venture capital: Biocon, Google, Oracle, Apple.

Clearly, there are benefits to venture funding, but it's not a good fit for everyone. It's critical for an entrepreneur to understand the venture dynamics, as Balaji Srinivas at Aureos Capital warned, "It is very important for the entrepreneur to know why the VCs are doing what they are doing."

 
3 defining characteristics of Venture Capital:
 
> Equity: a partner in your business
 
> High risk: able to invest in young, unproven companies
 
> Managed by professionals: benefits and limitations
 
Equity investment: a partner in your business
 
Venture capital is money invested that buys a share of ownership in your business - it's therefore referred to as equity capital. It is not a loan, as you might get from a bank. You would use these funds to grow your company.

Kanwal Singh, Helion: Very simply put, the model of a venture investor is investing behind a company as an equity partner. So that's one key difference between a bank and an investor.

Therefore the return you expect, whatever the time frame - three years, five years or seven years - is appreciation of the value of that equity. That is the upside for the risk you are taking.

 
Equity investment - Implications for you:
 
When you take venture capital, the venture capitalist will own shares in your company.
 
Your VC is a partner willing to take risk alongside you: no collateral or guarantees. If you lose, they lose. If you win, they win.
 
Equity matches the needs of a fast growing company. Unlike with debt, with equity you don’t have to make loan payments, so you can use your cash to build the business.
 
VC’s make money only if the value of their shares grows. Because they seek large increases in the value of their shares, VC’s will back you only if they think your company has very high growth potential.
 
As the word “partner” implies, VC’s will expect to have a say in how you run the company.
 
 
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High risk: able to invest in young, unproven companies
 
Venture capital is designed for risky investments: the investors in a venture capital fund have made a decision to pursue a high risk, high return strategy. These risk/return expectations match well with investment opportunities in young, potentially high-growth companies.

Alok Mittal, Canaan Partners: I don't think any of us expect to make super normal returns without taking risk that we can manage.

Bharati Jacob, Seedfund: Venture capital is essentially an art of taking risk. It is essentially defining the business model, and asking, What is the risk associated with it? Is there a way I can mitigate those risks or that the management the team can? Then in the long term, how do we build a great business?

 
High risk - Implications for you:
 
You can raise money from venture capitalists for a new business, one that does not yet have a history of making money. A bank, on the other hand, would require a track record of profits before lending you funds. .
 
Some venture capitalists will consider investing in your business before you have customers, and sometimes even during the product development phase.
 
 
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Managed by professionals: benefits and limitations
 
Venture capital is managed by investment professionals (venture capitalists or VCs). VCs are usually not investing their own money; they invest on behalf of others, usually pension funds, endowments, or very rich individuals.

Venture capitalists come from various backgrounds. But generally the leading VCs have been successful in operating roles, or as entrepreneurs, or have years of experience investing in young companies, usually in a specific industry.

These two factors combine to shape important dimensions of venture capital.

Benefits: More than Money

As experienced professionals, VCs can bring more than money to support the growth of a young company. And as partners in the business, they are motivated to spend their time helping the company grow.

Alok Mittal, Canaan Partners: I think what it brings in, more than money, is the expertise and the experience. So at Canaan, we don't call ourselves venture capitalist as much as venture catalysts.

 
Managed by professionals, benefits - Implications for you:
 
With the right venture capitalist, you can expect help with everything from strategy, to acquiring customers, to recruiting your team.
 
On the downside, if it's a bad match, it can be quite damaging. You may be stuck with a partner you find difficult, or someone who provides less help than you anticipated.

Therefore, before you take a VCs funds, you may want to do a few reference checks with entrepreneurs of their portfolio companies.

 
Limitations: Venture capitalists are in business to make money

Venture capitalists are in business to make money for the individuals or organizations that invested in their fund. Therefore, VCs primary responsibility is to return their investors' money, plus the appreciation in the value of their investments. As a result, sometimes the VCs priorities may not align with those of the entrepreneur or founders. This can be particularly true around the VCs need to cash in on their gains.

Because VCs own shares of a company, in order to return money to their investors, VCs have to "exit" the investment by selling their shares to someone else. Hopefully at a much higher price than the price they initially invested.

Venture capitalists' success is linked to how much money they are able to make for their investors. The higher their returns, the more money both they and their investors make, and the easier it is for the venture capitalist to raise more money from investors and stay in business.

Typically, there are two ways that VCs can "exit" an investment. One, the entire company is sold. Two, the company "goes public" with an initial public offering (IPO) and sells shares through a stock exchange. Once that happens, the venture capitalists and/or their investors are able to sell their shares of the company to the public as well.

An average VCs time frame for an investment, from the date of funding to the date of exit is usually within 5 - 7 years - just when things are getting a bit easier for the entrepreneur.

If the entrepreneur is not happy to sell at the time that the VCs wish to exit, and the company is not able to go public, there may arise a conflict of interest between the VCs and the entrepreneur.

Balaji Srinivas, Aureos: Ok, as a VC, I want to show exits in my portfolio, because I can go and tell my investors again: 'Please come back and invest with me, because I have shown you exits, I have given you money.'

 
Managed by professionals, limitations - Implications for you:
 
The moment you take venture funds, you have agreed either to sell your company, or take it public, to ensure the VCs are able to exit their investment.
 
Your investors' first responsibility is to their investors: they must maximize the return on their investments. This generally requires that their investments reach a large scale. In the event that the VCs feel the founder cannot achieve the scale they need, they would be inclined to hire a CEO for the company.
 
 
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