The Venture Capital Series: How Does Venture Capital Work?

Posted 29 March 2016 | BY Sansan

Venture capital is the biggest buzzword of the start-up world. Venture capital (VC) funds are the silent financers behind almost every start-up going for an initial public offering (IPO) or being acquired by a larger company. For an entrepreneur, it can be exciting and encouraging to know that people out there are willing to bet on a good idea and a great team. While there have been many articles on VC, what most tend to miss is the fact that, despite the buzz, many start-ups apply for funding and get turned away.

To help small business owners and start-ups negotiate the tricky waters of the world of venture capital, we answer four major questions.

  1. Why are VC funds popular with start-ups?

Most of today’s startups are in the unenviable position of having neither a revenue track record nor any significant collateral to offer. These two factors make them a big no-no from a bank or any other legitimate lender’s point of view. With regards to having collateral to offer, approaching markets through an IPO or raising investments through private equity (PE), companies have to have a certain amount of annual turnover along with strong corporate governance – both of which are not often found in start-ups. In this scenario, venture capital is the only real option for companies with great potential but that have not been established in these areas yet.

  1. What are venture capitalists looking to get out of an investment?

Venture capitalists are not angel investors. They are not looking to discover the next big idea and nurture it until it bears fruit. Most venture capitalists are looking to take a big risk for disproportionate value returns for a limited period of time. This is mostly 25 per cent to 35 per cent per year of investment for three to five years, with clear exit options at the end. The exit options could be a sale of its stake to a PE or an IPO.

  1. Who is the right target for venture capitalists?

This becomes clear once we understand the previous point. Venture capitalists usually target companies that have crossed the early stages, but are yet to reach a steady state. The company needs to be on an accelerated hockey-stick growth curve which will allow it to yield the returns and valuation that a venture capitalist seeks. Interest is also higher in on-trend industries for the simple reason that it is easier for venture capitalists to find a buyer for the next round. Finally, they tend to bet more on teams that can deliver ahead of the crowd for a particular sector.

  1. How should a company prepare itself to attract venture capital investment?

In order for a company to have a higher chance of being selected by a venture capitalist, it should keep the following in mind:

  • Fund requirements should be linked to milestones.
  • A list of exit options should be prepared with specifics. For example: A buyout by ABC Co., an international player, who is exploring options to enter the local market.
  • Ensure your organisation is ready for a financial and operations due diligence exercise.

Build stickiness into remuneration for key personnel. Using vested equity rewards is popular.