Venture Capital: An Opportunity to Grow Emerging Companies
Type of financing provided by investors allowing early-stage companies to grow faster
Wealthy individuals investing in small companies
IPO (Initial Public Offering):
Company entering the stock market
ROI (Return on Investment):
Yield rate of invested sum
What Venture Capital implies for the investors
First, venture capitalists are mainly venture capital firms or angel investors. Each of them receives a lot of financing requests every year, so their job is to evaluate which ones answer their own selection criteria and which ones have the highest potential to grow in the long-term. In venture capital, the investors are present at the beginning, during start-up phase, in the first financing rounds and then, they exit about 4 to 6 years later. Besides, the reason why venture capital is interesting is that the profit generated when a company succeeds exceeds the initial risk and the initial investments that were made in other companies.
Determining factors when selecting companies
To select a company potentially interesting in terms of growth, many think that the idea behind the start-up is the most important factor. However, that is not the case, it is rather the industry in which the product will be offered and the entrepreneur behind the idea that will be evaluated. Some criteria considered are the title of the entrepreneur, if the reputation and the vision of the founder match the venture capital firm’s values, if he can take risks and if he has the skills to sell himself. If the entrepreneur has the skills to make flourish an early-stage business, the risk of investing seems less important to the venture capitalists.
How do Venture Capital firms make their profit?
If we look more closely at the statistics, we can determine that about three companies out of four will fail to make profits: therefore, it is needed for firms to invest in many companies at the same time to ensure a ROI. Besides, when the investor exits the company is the moment when he can make his profit with three different possible ways: the company merges, the company is acquired, or the company becomes public. Most of the time, during the initial contract, the venture capitalist will accept to invest if he can have privileged actions of the company following their IPO.
How to determine the company value?
Considering the companies are possibly at their first financing round, and they have not yet generated revenues, not even costs, it is difficult for venture capital investors to evaluate the company value and, at the same time, the investment needed. Therefore, two methods are used to determine the value: the recent financing of similar companies and the profit potential when exiting the company. For the financing method, it is important to select companies in the same industry, but also in the same financing round during the last two years. For the profit potential when exiting, it is once again a question of comparing the IPO or the acquisition value of similar companies.
What do Venture Capitalists do daily?
Venture capital firms bring huge financial support to emerging companies, but they also act as external advisors within the team for the different decisions taken. This way, the investors can keep an eye on how the company uses the fund and the evolution of it, guiding the company on the right track when needed.
Figure : Diagram showing how venture capitalists spend their time.
The figure above represents how the venture capitalists distribute their time daily. Even though they are known to invest in companies, they occupy most of their time acting as mentors, as consultants, or even participating in the recruitment for these companies to encourage growth and development.
Different pitfalls to avoid as an entrepreneur seeking financing
We look a lot at what venture capitalists put on the table, but it is important to look at the actor that is most impacted by these investments: the entrepreneur. Many are new to the field and do not know much about venture capital: it is possible for them to come across one of these three pitfalls. The first one is convertible notes: the contract indicates that the company offers shares to the investor following the IPO. For them to reach a ROI, the investor can require having a discount that his competitors will not have for his shares, which is called a conversion cap. The second one is pro-rata fees: this allows investors to increase their participation share in the following rounds, not only guaranteeing to keep their initial share. This pitfall can lead to competitors’ withdrawal, that would have proposed more funding, so the entrepreneur will be at a disadvantage. The last one is participatory preferred shares: this allows the investor to retrieve completely his initial investment as well as a portion of the acquisition price, instead of only one of the two.
Therefore, venture capital is a great way to grow fast as an entrepreneur and a start-up, we only need to be vigilant and do some research prior to choosing an investment firm, just like the firms do when selecting their potential companies.
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Forbes. (2016). If You Know Nothing About Venture Capital, Watch This First. https://www.youtube.com/watch?v=a4aUX5u90oA
Les Finances. (2021). Qu’est-ce que le capital risque (Venture Capital)? https://lesfinances.ca/quest-ceque-le-capital-risque-venture-capital/
MaRS Startup Toolkit. (2021). Business valuation: How investors determine the value of your business. https://learn.marsdd.com/article/business-valuation-how-investors-determine-the-value-of-your-business/
Zider, Bob. (1998). How Venture Capital Works. Harvard Business Review. https://hbr.org/1998/11/how-venture-capital-works