Venture capital – or ‘VC’ as it’s often referred to – is an investment made to provide financial backing for a new company – a ‘start-up’ – that is thought to offer high growth potential, but that is both too small and too risky to be able to raise the finance it needs from either a bank loan or the commercial capital market.
The idea of venture capital started in the USA after World War Two; Georges Doriot, Ralph Flanders and Karl Compton established American Research and Development Corporation (ARDC) to provide private-sector investment to businesses founded by returning service personnel. Seventy years later, venture capital, as a method of finance, has become an essential component in the well-being of national, international and global economies.
During the last few decades, the pursuit of innovative, technological advances has moved away from in-house, corporate research and development departments, effectively being out-sourced to individuals who have a specific idea and then create a company to bring their idea to fruition. Venture capital provides these embryonic companies with the finance they need to provide innovative advances that affect every part of our daily life – it’s become one of the most important sources of investment funding in the UK economy.
Venture capital firms manage venture capital funds, investing them in start-up companies in exchange for equity, accepting potentially high risks in the hope that the new company will be successful and they’ll receive a high return on their investment. With so much at stake, venture capital firms do everything they can to help the start-up business succeed, frequently offering facilities, mentoring, managerial and technical experience and access to resources in addition to the finance provided.
There are a number of ways that venture capital investors receive a return, ‘how and when’ depending on the type of venture capital investment they’ve made. Commonly, most wait until the start-up either floats on a stock exchange and offers shares at an initial public offer (IPO) or is acquired by an established organisation; however, some investors will want to sell their shares at a predetermined point in the start-up’s growth, ‘passing the torch’ to another investor who may be better equipped to help the new company through the next stage in its growth.
The start-up companies that venture capital investors are interested in are usually within the technology sector – information technology (IT), financial technology, e-commerce and biotechnology, for example, and are often referred to as ‘tech companies’ – as it is within this sector that most investors see the potential for innovative ideas that could bring the levels of commercial success that would result in high returns. But, as with any form of investment, there’s always a risk – the possibility of high returns is accompanied by high levels of risk which makes pre-investment due diligence exceptionally important.
Development and financing stages
Most start-up businesses pass through four key stages in their initial development. Each stage brings different challenges in terms of what the company has to achieve and the level of finance it needs to be able to move to the next stage. This means that most are looking for specific types of investment, possibly as part of a package of support, rather than just financial assistance.
1. ‘Early-stage’ development.
Having been set up, possibly to develop a single, potentially original idea, the new start-up company will need money to prove the idea. Although this may be relatively inexpensive, it may mean it has to invest in people, premises, capital equipment and raw materials. Being in a development stage, the new company won’t be generating any revenue so won’t be able to offer an investment return.
Having proven its idea, the new company has to then market and sell the outcome of its idea until it starts to break-even, when its costs are covered by its revenue. This period of time is often called ‘The Valley of Death’ on a revenue / time graph as, unless the company can break-even, its days are usually numbered.
Having reached break-even, the new company starts to grow and return a profit. More money will have to be invested to help it expand into becoming a profitable company.
The new company eventually reaches a point where it is standing on its own two feet and is making a profit. It’s at this stage that venture capital investors will expect a return on their investment – either by the company offering shares at an IPO or by being acquired by a larger, more established organisation – leading to their exiting the investment process.
Finance is needed at each stage in the process. Initially, the amount of financial backing required may be relatively low but, as the company grows and has to bring its idea to market – and do so profitably – the amount of money it needs can grow dramatically. In the ‘idea development’ and ‘start-up’ stages, new companies look for what is called, appropriately, ‘seed capital’ – to help it grow from, hopefully, from a seed to an oak tree. In addition, each stage can carry a different level of risk, the risk level usually decreasing as the new company starts to generate revenue, breaks even and then heads towards the venture capital investor’s exit event.
As a result, different types of venture capital investor can become involved at different times in the company’s development, sometimes buying out a previous venture capital investor; for example, a venture capital fund may buy out an angel investor’s stake. From inception to the point at which break-even happens, finance usually comes from angel investors, accelerators or crowdfunding; after break-even, venture capital funds will want to become involved; if it’s an entrepreneurial idea that has specific benefits in a particular market, corporate venture capital may be offered.
Types of venture capital investor
Venture capital investors fall into five typical categories.
1. Angel investors
These are high-net-worth individuals who use their own funds as an investment. They may be former entrepreneurs and tend to invest at an early stage. Apart from financial backing, they may also be able to offer expert advice, sometimes from personal experience as an entrepreneur, and have a useful network of industry contacts. Angel groups may aggregate their members’ funds, increasing the total investment for a start-up business and reducing the risk to individual members. A high-profile ‘angel’ is Lord Sugar, ‘The Apprentice’ being a televised selection process resulting in him providing funding, mentoring and resources to help develop the eventual winner’s idea.
Online platforms that aggregate small amounts from many individual investors. A benefit of crowdfunding is that attracting multiple investors demonstrates both support for the idea and provides a broad and varied network of support.
A ‘cohort’ programme offered by ultra-high-net-worth individuals, corporations and not-for-profit organisations, eg: universities, that provides groups of entrepreneurs with financial backing, resources and mentoring in a predetermined package. The start date, duration and level of funding and support is often fixed; unsuccessful ideas falling by the wayside as the process continues.
4. Venture capital funds
The capital is provided by ultra-high-net-worth individuals, corporations, pension funds and university endowments, structured as limited partnerships. Apart from finance, venture capital funds may also offer operational support and mentoring either provided from retained experts or through a network of contacts.
5. Corporate venture capital
Having reduced their expensive in-house R&D budgets, corporations are always looking for entrepreneurs who have an idea that may be of future commercial benefit to them. Apart from finance, corporate venture capital investment can also bring the might of the corporation’s resources into play, something that can fast-track a start-up to success.
Tax-advantaged venture capital schemes
The health of the economy relies on a steady stream of innovative ideas being successfully developed to prevent it from becoming stagnant. Understanding this need, the government has set in place, and periodically fine tunes, venture capital schemes that help start-ups raise money by incentivising investment through investor tax relief.
These schemes include the Seed Enterprise Investment Scheme (SEIS), the Enterprise Investment Scheme (EIS), Social Investment Tax Relief (SITR) and venture capital trusts (VCTs) – which are covered in Tax-advantaged venture capital schemes.
Start-up companies are often in a position to be able to choose who they receive funding from as having an exceptionally innovative idea may mean venture capital investors are tripping over themselves to ‘get a piece of the action’. It could result in fierce competition between large corporations who may see the idea as providing a competitive edge and want to secure both the idea and its outcome for their own use. Conversely, those behind the idea may not want to give up too much of their company’s future success and limit the amount of equity they are prepared to exchange, preferring to raise the money they need through crowdfunding or driving an exceptionally hard bargain. These considerations may mean that investors have to compete for the investment opportunity, proactively negotiating a tailor-made proposition that balances the level of return they want to achieve with the start-up company’s own objectives.
How can One Financial Solutions help you?
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