Corporate Finance: Venture Capital

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Definition of Venture Capital? Meaning.

In Corporate Finance, Venture Capital is the private or institutional financial capital (money, investment) provided to relatively early-stage companies (ventures).

Venture Capitalists are outside investors financing new (start-up), growing or struggling companies (turnaround). Such investments generally are high risk, but offer the potential for above average returns when the company files their Initial Public Offering. VC's are often wealthy former (chief) executives at firms similar to those which the partnership funds or subsidiaries of banks and other institutions with large amounts of available venture capital.

Conditions of Venture Capital

Venture capital investments can take the form of either preferred stock equity or a combination of equity and debt obligation, often with convertible debt instruments that become equity if a certain level of risk is exceeded. The common stock is often reserved by covenant for a future buyout, as VC investment criteria usually include a planned exit event (an IPO or acquisition), normally within three to seven years.

In most cases, one or more general partners of the investing fund joins the Board of Directors of the new venture, and will often help to recruit personnel to key management positions.

Suitability of Venture Capital. Candidates

Venture capital is especially suitable for high-tech entrepreneurs, as venture capitalists often keen on ventures with high growth potential, as only such opportunities are likely capable of providing the financial returns and successful exit event within the required timeframe that venture capitalists expect.

Sometimes VC's specialize in providing certain types of venture capital, including seed money (to establish a Start-up Company), first round financing, Venture Funding, second round financing, and mezzanine level financing (immediately preceding an IPO).

Differences Between Venture Capital Funds and Business Angels

In their study on Business Angels (BAs) in Germany, Kraemer and Schillo (2011) listed the main differences between BAs and Venture Capital funds (VCs). While these are not exclusive and may vary across funds and individuals, the main distinctions between the two include the following:

1. BACKGROUND: While BAs themselves usually have entrepreneurship experience, VCs represent former finance professionals, consultants and specialists from specific industries.
2. INVESTMENT APPROACH: BAs usually invest their own funds resulting in smaller contributions and transaction costs. VCs, in contrast, act as intermediaries investing amounts of other investors.
3. INVESTMENT TIMING: While BAs may invest in any stage of the development of start-ups, their focus is mainly on seed and early stage ventures. VCs would invest in seed stage companies only in exceptional cases focusing more on early and later stage start-ups.
4. INVESTMENT INSTRUMENTS: While BAs normally receive common shares as exchange to their contributions, VCs seek to obtain preferred shares.
5. DEAL FLOW: BAs obtain information about investment opportunities from networks and angel groups. VCs' deal flow is more formalized with official proposal submission process.
6. DUE DILIGENCE: BAs normally conduct due diligence on targets by themselves. VCs have teams of frequently outside experts (lawyers, accountants, etc.) perform standardized due diligences on target companies for them;
7. GEOGRAPHICAL REACH: Most of BAs investments are locally based; VC funds increasingly invest on an international scale.
8. INVOLVEMENT WITH THE BUSINESS: BAs approach is very much hands-on contributing with their knowledge and network. VCs usually participate in the boards of their investment companies and have a strategic role.
9. RETURNS: achieving returns may represent only one of numerous reasons why BAs invest in particular ventures. On the contrary, generating returns for VCs is their ultimate goal for investing and to enable them to raise further funds for next investments.

Negotiating with Venture Capitalists. Terms and Best Practices

Negotiating a VC-deal is complex and the stakes are high, given the inherent uncertainty, risks and rewards of investing in a new startup company. For both the entrepreneur and the VC. That's why it's very important to have a good basic understanding of negotiating. The VC industry has its own protocols and language, and its advisable to have professional legal assistance (a lawyer specialized in VC deals) to assist with the many provisions present in a VC contract, such as liquidation preference, anti-dilution protection, pay to play, drag along rights, vesting schedules, etc. In his article "How to negotiate with VCs" (HBR, May 2013) Deepak Malhotra recommends the following 4 best practices in dealing with VCs:

• Understand your Leverage. What alternative funding / VC options do you have? Make sure you negotiate enough / plenty of cash in early financing rounds and avoid a situation of running out of cash and still having to renegotiate a new round of funding. Negotiate certain terms for a second round of funding already during the first round.
• Maximize Trust. Transparency is often less costly then you fear and helps to build long-term trust. Always play it straight. Especially when the other party is vulnerable.
• Focus on Value. Don't focus only on the initial valuation, investment level end equity dilution. Consider all long-term success scenarios for the future of your firm and calculate what the various terms would yield in each case. Don't give away the control over the company too easily in return for a more favorable valuation.
• Strive for Understanding. The terms that a VC proposes reveal how she views the prospects of your firm as well as concerns.

Source: Kraemer, H. and Schillo, M. (2011). Business Angels in Germany: EIFs Initiative to Support the Non-institutional Financing Market. EIF Research & Market Analysis. Luxembourg: European Investment Fund.

Compare with: Initial Public Offering  |  Venture Funding  |  Exit Strategy  |  Vulture Capitalist  |  Turnaround Management

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