Venture capital financing is a type of funding by

venture capital Venture capital (often abbreviated as VC) is a form of private equity financing that is provided by venture capital firms or funds to startups, early-stage, and emerging companies that have been deemed to have high growth potential or which h ...

. It is

private equity In the field of finance, the term private equity (PE) refers to investment funds, usually limited partnerships (LP), which buy and restructure financially weak companies that produce goods and provide services. A private-equity fund is both a t ...

capital that can be provided at various stages or funding rounds. Common funding rounds include early-stage seed funding in high-potential, growth companies (

startup companies A startup or start-up is a company or project undertaken by an entrepreneur to seek, develop, and validate a scalable business model. While entrepreneurship refers to all new businesses, including self-employment and businesses that never intend t ...

) and growth funding (also referred to as

series A A series A round (also known as series A financing or series A investment) is the name typically given to a company's first significant round of venture capital financing. The name refers to the class of preferred stock sold to investors in exc ...

). Funding is provided in the interest of generating a

return on investment Return on investment (ROI) or return on costs (ROC) is a ratio between net income (over a period) and investment (costs resulting from an investment of some resources at a point in time). A high ROI means the investment's gains compare favourably ...

or ROI through an eventual exit through a share sale to an investment body, another trading company or to the general public via an

Initial public offering An initial public offering (IPO) or stock launch is a public offering in which shares of a company are sold to institutional investors and usually also to retail (individual) investors. An IPO is typically underwritten by one or more investme ...

(IPO). Venture Capital can be made in four methods: 1) Equity Financing; 2) Conditional Loan; 3) Income Note; and 4) Participating Debenture.

Overview

Starting a new venture or launching a new product in the market requires funding. There are several categories of financing possibilities depending on the scope of a venture. Smaller ventures sometimes rely on friends and family funding, loans, or

crowd funding Crowdfunding is the practice of funding a project or venture by raising money from a large number of people, typically via the internet. Crowdfunding is a form of crowdsourcing and alternative finance. In 2015, over was raised worldwide by crow ...

. For more ambitious projects, some companies need more than what was mentioned above, some ventures have access to rare funding resources called

angel investor An angel investor (also known as a business angel, informal investor, angel funder, private investor, or seed investor) is an individual who provides capital for a business or businesses start-up, usually in exchange for convertible debt or ownersh ...

s. These are private investors who are using their own capital to finance a venture's need. The Harvard report by William R. Kerr, Josh Lerner, and Antoinette Schoar tables evidence that angel-funded

are less likely to fail than companies that rely on other forms of initial financing. Apart from these investors, there are also venture capital firms ( VC firms) who specialize in

financing Funding is the act of providing resources to finance a need, program, or project. While this is usually in the form of money, it can also take the form of effort or time from an organization or company. Generally, this word is used when a firm use ...

new ventures against a lucrative return. More ambitious projects that need more substantial funding may turn to

s or angel groups - private investors who use their own capital to finance a venture's need, or

(VC) companies that specialize in financing new ventures. Venture capital firms may also provide expertise the venture is lacking, such as legal, strategy, or marketing knowledge. This is particularly the case in the Corporate venture capital context where a startup can benefit from a corporation, for instance by capitalizing on the corporation's brand name.

Strategies

An investment strategy defines in part the identity of a firm that engages in the provision of venture capital financing. It need be neither unitary nor unchanging. One strategy relates to the subject matter expertise of personnel at the funding firm; if the firm members have expertise in the transportation industry, their funding transportation startups would be a logical choice based on their understanding of the industry, while their funding of franchise restaurants, less so. Another strategy is to align with a set of known serial entrepreneurs who have a demonstrated success at establishing start-ups that accrue value and

. An emerging strategy is one based on

machine learning Machine learning (ML) is a field of inquiry devoted to understanding and building methods that 'learn', that is, methods that leverage data to improve performance on some set of tasks. It is seen as a part of artificial intelligence. Machine ...

with a focus on likely investments with a high return on investment.

Process

There are five common stages of venture capital financing: #Pre-seed funding , Concept stage # Seed stage #Post-seed / pre-third stage , Bridge round #Third stage ,

Series A A series A round (also known as series A financing or series A investment) is the name typically given to a company's first significant round of venture capital financing. The name refers to the class of preferred stock sold to investors in exc ...

#Fourth stage , Series B #Pre-

initial public offering An initial public offering (IPO) or stock launch is a public offering in which shares of a company are sold to institutional investors and usually also to retail (individual) investors. An IPO is typically underwritten by one or more investme ...

(IPO) stage The number and type of stages may be extended by the venture capital firm if it deems necessary; this is common. This may happen if the venture does not perform as expected due to bad management or market conditions (see: Dot com boom). The following schematics shown here are called the process data models. All activities that find place in the venture capital financing process are displayed at the left side of the model. Each box stands for a stage of the process and each stage has a number of activities. At the right side, there are concepts. Concepts are visible products/data gathered at each activity. This diagram is according to the modeling technique developed by

Sjaak Brinkkemper Jacobus Nicolaas (Sjaak) Brinkkemper (born Monnickendam, 18 January 1958) is a Dutch computer scientist, and Full Professor of organisation and information at the Department of Information and Computing Sciences of Utrecht University. Biography Br ...

of the University of Utrecht in the Netherlands.

Seed stage

This is where the seed funding takes place. It is considered as the setup stage where a person or a venture approaches an

or an investor in a venture capital firm for funding for their idea/product. During this stage, the person or venture has to convince the investor why the idea/product is worthwhile. The investor will investigate the technical and economical feasibility (

feasibility study A feasibility study is an assessment of the practicality of a project or system. A feasibility study aims to objectively and rationally uncover the strengths and weaknesses of an existing business or proposed venture, opportunities and threats pr ...

) of the idea. In some cases, there is some sort of prototype of the idea/product that is not fully developed or tested. If the idea is not feasible at this stage, and the investor does not see any potential in the idea/product, the investor will not consider financing the idea. However, if the idea/product is not directly feasible, but part of the idea is worthy of further investigation, the investor may invest some time and money in it for further investigation.

Example

A Dutch venture named High 5 Business Solution V.O.F. wants to develop a portal that allows companies to order lunch. To open this portal, the venture needs some financial resources, they also need marketeers and market researchers to investigate whether there is a market for their idea. To attract these financial and non-financial resources, the executives of the venture decide to approach ABN AMRO Bank to see if the bank is interested in their idea. After a few meetings, the executives are successful in convincing the bank to take a look in the feasibility of the idea. ABN AMRO decides to involve their own experts for further investigation. After two weeks, the bank decides to invest. They come to an agreement and invest a small amount of money into the venture. The bank also decides to provide a small team of marketeers and market researchers and a supervisor. This is done to help the venture with the realization of their idea and to monitor the activities in the venture.

Risk

At this stage, the risk of losing the investment is tremendously high, because there are so many uncertain factors. The market research may reveal that there is no demand for the product or service, or it may reveal that there are already established companies serving this demand. Research by J.C. Ruhnka and J.E. Young shows that the risk of the venture capital firm losing its investment is around 66.2% and the causation of major risk by stage of development is 72% . The Harvard report by William R. Kerr, Josh Lerner, and Antoinette Schoar, however, shows evidence that angel-funded

are less likely to fail than companies that rely on other forms of initial financing.

Start-up stage

If the idea/product/process is qualified for further investigation and/or investment, the process will go to the second stage; this is also called the start-up stage. A

business plan A business plan is a formal written document containing the goals of a business, the methods for attaining those goals, and the time-frame for the achievement of the goals. It also describes the nature of the business, background information on ...

is presented by the attendant of the venture to the venture capital firm. A management team is being formed to run the venture. If the company has a board of directors, representatives from the venture capital firms will take seats at the

board of directors A board of directors (commonly referred simply as the board) is an executive committee that jointly supervises the activities of an organization, which can be either a for-profit or a nonprofit organization such as a business, nonprofit orga ...

. While the organisation is being set up, the idea/product gets its form. The prototype is being developed and fully tested. In some cases, clients are being attracted for initial sales. The management-team establishes a feasible production line to produce the product. The venture capital firm monitors the feasibility of the product and the capability of the management-team from the

. To prove that the assumptions of the investors are correct about the investment, the venture capital firm wants to see the results of

market research Market research is an organized effort to gather information about target markets and customers: know about them, starting with who they are. It is an important component of business strategy and a major factor in maintaining competitiveness. Ma ...

to see if there are sufficient consumers to buy their product (market size). They also want to create a realistic forecast of the investment needed to push the venture into the next stage. If at this stage, the venture capital firm is not satisfied about the progress or market research results, the venture capital firm may stop their funding and the venture will have to search for another investor(s). When there is dissatisfaction and it is related to management performance, the investor may recommend replacing all or part of the management team.

Example

Now the venture has attracted an investor, the venture needs to satisfy the investor to invest further. To do that, the venture needs to provide the investor a clear business plan, idea realisation, and how the venture is planning to earn back the investment that is put into the venture, of course with a lucrative return. Together with the market researchers, provided by the investor, the venture has to determine how big the market is in their region. They have to find out who are the potential clients and if the market is big enough to realise the idea. From market research, the venture realises that there are enough potential clients for their portal site. But there are no providers of lunches yet. To convince these providers, the venture decides to interview providers and try to convince them to join. With this knowledge, the venture can finish their business plan and determine a forecast of the revenue, the cost of developing and maintaining the site, and the profit the venture will earn in the following five years. After reviewing the business plan and consulting the person who monitors the venture activities, the investor decides that the idea is worth further development.

Risk

At this stage, the risk of losing the investment is shrinking because the nature of any uncertainty is becoming clearer. The venture capital firm's risk of losing the investment has dropped to 53.0%. However, the causation of major risk becomes higher (75.8%), because the prototype was not fully developed and tested at the seed stage. The venture capital firm could have underestimated the risk involved, or the product and the purpose of the product could have changed during development.

Third stage

At this stage, we presume that the idea has been transformed into a product and is being produced and sold. This is the first encounter with the rest of the market, the competitors. The venture is trying to squeeze between the rest and it tries to get some market share from the competitors. This is one of the main goals at this stage. Another important point is the

cost In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something or deliver a service, and hence is not available for use anymore. In business, the cost may be one of acquisition, in whic ...

. The venture is trying to minimize their losses in order to reach the

break-even Break-even (or break even), often abbreviated as B/E in finance, (sometimes called point of equilibrium) is the point of balance making neither a profit nor a loss. Any number below the break-even point constitutes a loss while any number above it ...

. The management team has to handle this decisively. The venture capital firm monitors the management capability of the team. This consists of how the management team manages the development process of the product and how they react to competition. If at this stage the management team is proven their capability of standing hold against the competition, the venture capital firm will probably give a go for the next stage. However, if the management team lacks in managing the company or does not succeed in competing with the competitors, the venture capital firm may suggest for restructuring of the management team and extend the stage by redoing the stage again. In case the venture is doing tremendously bad whether it is caused by the management team or from competition, the investor will cut the funding.

Example

The portal site needs to be developed. (If possible, the development should be taken place in house. If not, the venture needs to find a reliable designer to develop the site.) Developing the site in house is not possible; the venture does not have this knowledge in house. The venture decides to consult this with the investor. After a few meetings, the investor decides to provide the venture a small team of web-designers. The investor also has given the venture a deadline when the portal should be operational. The deadline is in three months. In the meantime, the venture needs to produce a client portfolio, who will provide their menu at the launch of the portal site. The venture also needs to come to an agreement on how these providers are being promoted at the portal site and against what price. After three months, the investor requests the status of development. Unfortunately for the venture, the development did not go as planned. The venture did not make the deadline. According to the one who is monitoring the activities, this is caused by the lack of decisiveness by the venture and the lack of skills of the designers. The investor decides to cut back their financial investment after a long meeting. The venture is given another three months to come up with an operational portal site. Three designers are being replaced by a new designer and a consultant is attracted to support the executives’ decisions. If the venture does not make this deadline in time, they have to find another investor. Luckily for the venture, with the come of the new designer and the consultant, the venture succeeds in making the deadline. They even have two weeks left before the second deadline ends.

Risk

At this stage, the risk decreases because the start-up is no longer developing its product, but is now concentrating on promoting and selling it. These risks can be estimated. The risk to the venture capital firm of losing the investment drops from 53.0% to 33.7%, and the causation of major risk by stage of development also drops at this stage, from 75.8% to 53.0%.Ruhnka, J.C., Young, J.E.

Fourth stage

This stage is seen as the expansion/maturity phase of the previous stage. The venture tries to expand the market share they gained in the previous stage. This can be done by selling more of the product and having a good marketing campaign. Also, the venture will have to see whether it is possible to cut down their production cost or restructure the internal process. This can become more visible by doing a

SWOT analysis SWOT analysis (or SWOT matrix) is a strategic planning and strategic management technique used to help a person or organization identify Strengths, Weaknesses, Opportunities, and Threats related to business competition or project planning. It ...

. It is used to figure out the strength, weakness, opportunity and the threat the venture is facing and how to deal with it. Apart from expanding, the venture also starts to investigate follow-up products and services. In some cases, the venture also investigates how to expand the life-cycle of the existing product/service. At this stage the venture capital firm monitors the objectives already mentioned in the second stage and also the new objective mentioned at this stage. The venture capital firm will evaluate if the management team has made the expected cost reduction. They will also examine how the venture competes against the competitors. The new developed follow-up product will be evaluated to determine its potential.

Example

Finally, the portal site is operational. The portal is getting more orders from the working class every day. To keep this going, the venture needs to promote their portal site. The venture decides to advertise by distributing flyers at each office in their region to attract new clients. In the meanwhile, a small team is being assembled for sales, which will be responsible for getting new lunchrooms/bakeries, any eating-places in other cities or regions to join the portal site. This way the venture also works on expanding their market. Because of the delay at the previous stage, the venture did not fulfil the expected target. From a new forecast, requested by the investor, the venture expects to fulfil the target in the next quarter or the next half year. This is caused by external issues the venture does not have control of it. The venture has already suggested to stabilise the existing market the venture already owns and to decrease the promotion by 20% of what the venture is spending at the moment. This is approved by the investor.

Risk

At this stage, the risk to the venture capital firm of losing the investment drops from 20.1% to 13.6%, and the causation of major risk by stage of development drops substantially from 53.0% to 37.0%. However, new follow-up products are often being developed at this stage. The risk of losing the investment is still decreasing, because the venture relies on its income from sales of the existing product.

Bridge/pre-IPO stage

In general, this is the last stage of the venture capital financing process. The main goal of this stage is for the venture to go public so that investors can exit the venture with a profit commensurate with the risk they have taken. At this stage, the venture achieves a certain amount of market share. This gives the venture some opportunities, for example: *

Merger Mergers and acquisitions (M&A) are business transactions in which the ownership of companies, other business organizations, or their operating units are transferred to or consolidated with another company or business organization. As an aspec ...

with other companies * Keeping new competitors away from the market * Eliminate competitors Internally, the venture has to examine the product's market position and, if possible, reposition it to attract new

Market segmentation In marketing, market segmentation is the process of dividing a broad consumer or business market, normally consisting of existing and potential customers, into sub-groups of consumers (known as ''segments'') based on some type of shared charact ...

. This is also the phase to introduce the follow-up product/services to attract new clients and markets. Ventures have occasionally made a very successful initial market impact and been able to move from the third stage directly to the exit stage. In these cases, however, it is unlikely that they will achieve the benchmarks set by the venture capital firm.

Example

Faced with the dilemma of whether to continuously invest or not. The causation of major risk by this stage of development is 33%. This is caused by the follow-up product that is introduced.

Total risk

As mentioned in the first paragraph, a venture capital firm is not only about funding and lucrative returns, but it also offers knowledge support. Also, as can be seen below, the amount of risk (of losing investment value) decreases with each additional funding stage

History

In July 2016, the

Financial Post The ''Financial Post'' was an English Canadian business newspaper, which published from 1907 to 1998. In 1998, the publication was folded into the new ''National Post'',"Black says Post to merge with new paper". ''The Globe and Mail'', July 23, ...

reported that according to a report by

PricewaterhouseCoopers PricewaterhouseCoopers is an international professional services brand of firms, operating as partnerships under the PwC brand. It is the second-largest professional services network in the world and is considered one of the Big Four accounti ...

and the National Venture Capital Association, venture-capital funding in

Silicon Valley Silicon Valley is a region in Northern California that serves as a global center for high technology and innovation. Located in the southern part of the San Francisco Bay Area, it corresponds roughly to the geographical areas San Mateo Cou ...

fell 20% in the second quarter from a year earlier.

Overview

Strategies

Process

Seed stage

Example

Risk

Start-up stage

Example

Risk

Third stage

Example

Risk

Fourth stage

Example

Risk

Bridge/pre-IPO stage

Example

Total risk

History

See also

References

Further reading