What is a Venture Capital Firm
Venture capital is a form of private equity and venture capital firm is a company that has a pool of private investors that fund small startup businesses. Venture capital is also called ‘risk capital’ due to its inherent risk. They are interested in recovering their finance with a maximum return and take active participation in business’s decision making due to this risk.
How does Venture Capital Work
It is vital to have a lucrative business plan to approach a venture capital firm and to attract their interest in investing in your business. It is very unlikely that a venture capital firm will be willing to invest in a ‘business idea’. They will be more interested in investing in a business already originated through some form of capital (personal funding of the founders\ loan capital) in order to materialize a significant expansion rapidly. If a startup business is interested in considering gaining access to funds through a venture capital firm they should present a sound business plan with clear strategic goals for the near future, preferably for the next 2-3 years.
Once the above is done, a series of documents will be drafted and signed as a part of the process. A document called the Term sheet takes priority here. This is the main document that specifies the financial and other indications of the proposed investment including the amount of funds to be invested etc. Provisions of a Term Sheet are not usually legally binding (with the exception of certain clauses – such as confidentiality, exclusivity, and costs). Subsequent documents include any other agreements that include information pertaining to the subscription of shares, payment terms and any other contract specific details.
Rights of the Venture Capital Investors Granted by the Term Sheet
When an investor becomes a shareholder of the business he or she is entitled to a periodic return of sums out of profits called dividend. Dividends can be paid out to the shareholders or can be reinvested in the business. Venture capitalists may emphasize that dividends may be reinvested. This is often agreed at the beginning of the contract.
At the time of terminating the contract, venture capitalist firm is entitled to receive an amount of proceeds before other parties.
Venture capitalists require the company to provide them with regular updates regarding its financial condition and budgets, as well as a general right to visit the company and examine its accounts and records.
Formation of the Agreement and Engagement
The formation of the agreement between the business and the venture capitalists is often a time consuming and lengthy process; once agreed by all parties, lawyers use the Term Sheet as a basis for drafting the subsequent investment documents. Furthermore, the parties involved are bound by a Confidentiality Agreement and this agreement is executed as soon as discussions about a potential investment with the company begin.
Once the venture capital firm injects the funds into the business they will require an equity ownership percentage. In general, this equity ownership may range from 20%-25%, this may increase into a controlling stake in certain situations. Venture capital firm will actively engage in the decisions of the business and their bargaining power will be decided by the percentage of ownership they represent.
The engagement of the venture capital firm in the business’s activities is done through the directors appointed by venture capital firm. These directors will participate in the matters of the business where important decisions should be taken.
Once the business is adequately established, the venture capital firm will exert an exit strategy to withdraw itself from the business. There are 4 commonly exercised exit routes for venture capitalists, which are,
- Offering shares to the general public by listing on a stock exchange (Initial Public Offering)
- Sale of the business to another company (Mergers and Acquisitions)
- Founders can buy back the venture capitalist’s stake in the business (Share repurchase)
- Venture capitalist sells its shares to another venture capitalist or a similar nature strategic investor (sale to other strategic investors)
Advantage and Disadvantages of Using Venture Capital as a Funding Option
- Access to a significant amount of financing that is seldom available with other alternative financing options
- Expertise business advice from experienced business consultants
- Venture capitalists often actively get involved with the decision making of the business. If the views of the founders and directors appointed by venture capital firm do not match with one another conflicts may arise
- If the venture capital percentage of ownership exceeds 50% (this is possible in certain arrangements) the founders will lose the control of the businesses.