A brief overview of Venture Capital
LR#1. My learning recap series. I work in a Swiss philanthropic pre-seed technology fund, and am looking to expand and share my knowledge on the industry. This post aims to explain what Venture Capital is in a nutshell.
What is Venture Capital?
Venture capital is a specific case of private equity, where an investment is made in the very early stages of a company’s life. Broadly, private equity is both an investment made by investors in the equity of a private company as well as a source of financing for private companies. It is an alternative to other sources of liquidity (such as a loan or an initial public offering (IPO)) for the company receiving the financing.
Why do we need it?
Invention and innovation drive modern economies. In today’s increasingly dynamic and global economy, fostering and developing innovation is critical to sustaining a company’s or even a country’s competitive edge.
So where does Venture Capital fit in?
Venture capital plays an important role in the next stage of the innovation life cycle, the period in a company’s life when it begins to commercialize its innovations. It is estimated that over 80% of the money invested by venture capitalists goes into building the infrastructure required to grow a business — in expense investments such as manufacturing, marketing, sales and the balance sheet such as providing fixed assets and working capital. (HBR, 1998)
Due to the structure and regulations of capital markets, the venture capital niche plays an important role in providing capital to this segment of the innovation chain. Traditional lenders such as banks do not finance such ventures due to the inherent risk that they carry — this justifies interest rates typically much higher than usury laws permit. Moreover, in today’s information economy, many new ventures have few hard-assets to offer as collateral for traditional lending channels. Public markets are also typically not accessible, where the usual threshold of $10 million of annual revenue acts as a barrier to entry to young ventures.
Who are the main players in the VC industry?
The venture capital industry has four main players:
i) entrepreneurs who need funding, ii) investors looking for high returns, iii) investment bankers who need companies to sell, iv) the venture capitalists who make money for themselves by making a market for the other three players. This is how they interact:
A fifth potential player takes shape under the form of existing companies looking to acquire startups, either looking to secure intellectual property, performing an acqui-hire to recruit their employees, or to outright integrate the startup’s business into their own. The M&A exit route is an alternative to IPOs, and is for example very popular in the life sciences industry.
The direct and indirect benefits of Venture Capital
A venture-backed company wants to enjoy some direct and indirect benefits that a company can exploit when financed by a venture capitalist, such as:
a) Certification Benefit
b) Network Benefit
c) Knowledge Benefit
d) Financial Benefit
Let’s take a look at these in more detail:
a) The Certification Benefit
Due to the high level of risk associated with investing in young ventures with close to no track-record, a venture capitalist goes through a long screening phase (in other words, due diligence) before deciding to invest in a company. Given the venture capitalist’s investment track-record, this may confirm the venture’s quality to other players in the market. This signal of health and of high-quality can be used as a promotion for the venture-backed company’s brand.
b) The Network Benefit
The venture-capitalist can give the venture-backed company access to a very strong network, in terms of suppliers, customers and banks therefore multiplying its possible contacts.
c) The Knowledge Benefit
The venture capitalist aims to transfer knowledge to a portfolio company to increase its likelihood for growth and success. There are types of knowledge that can be transferred:
i) soft knowledge = the capability to manage the business
ii) hard knowledge = this being the specific-knowledge of a business, this usually applying to particularly high-tech or pharmaceutical industries
Overall, the investor plays the role of both an adviser and mentor.
d) The Financial Benefit
The financial benefit is generated through the injection of cash in return for shares of the venture-backed company. The increase generates the following effect on the cost of capital: an increase in equity leads to an increase in rating, which results in a positive effect on the cost of capital.
The different stages of Venture Capital financing
A company’s life cycle can be broken down as six life stages:
As previously mentioned, venture capital is deployed in the next stage of the innovation life cycle, the period in a company’s life when it begins to commercialize its innovations. The venture capital sub-sample encompasses three of the six life stages as seen above: the development stage, the startup stage, and the early growth stage. Depending on a venture capitalist’s investment strategy, it may decide to invest during one or several of these life cycle stages.
How do the venture capital sub-sample life stages and corresponding investments differentiate?
a) Development Stage
The life cycle starts with development. It is the moment in which the founders start to create and try to formalize their business case, where founders assess the viability of their idea. The corresponding investment for this stage is called seed funding.
b) Startup Stage
Once a startup has validated its business case and assured itself of its product-market fit, this is when it officially begins its operations. The corresponding investment is called startup financing.
c) Early Growth Stage
This stage represents the moments when the company starts its growth, and begins to generate a consistent source of revenue. Cash flow should start to improve as recurring revenues help to cover some of the ongoing expenses, but outside investment is still required to scale at a rapid rate. The corresponding investment is the early growth financing, otherwise known as “the financing of the day after.”
If you wish to learn more about the different stages of venture capital financing, stick around for a future post!
Conclusion
Venture capital is a subset of private equity investing, where the investment is made in the very early stages of a company’s life. The injection of capital in this very early stage of the innovation chain is critical in sustaining a company’s and even a country’s competitive edge in global and dynamic markets. Venture-backed companies not only benefit financially, but also benefit from the transfer of knowledge, access to its investors’ network, as well as from the certification effect.
Venture capitalists may choose to invest in one or several of the venture capital sub-sample of a company’s life stages. Overall, the investment is often characterized by a high level of risk. The investor needs to have a hands-on approach and have a very deep knowledge of the field where the company operates in to best increase its chances to succeed.
Next steps
If you are interested in discussing the venture capital industry and tech space with me, or have any feedback concerning my post, I’d love to hear from you! Please reach out to timothy.vibert@gmail.com.
