With constantly evolving technologies and consumer preferences driving the pace and shaping the direction of innovations worldwide, startups have become the new face of business. And the role of venture capitalists in this journey cannot be understated. VCs offer funds to startups with the expectations of higher returns in the mid-to-long term despite the risk of losses in the short-term. For startups that are beginning the journey or those that have progressed till growth stage with bootstrapped funds, VC funding is a whole new ball game, and here is everything there is to know about VC funding for startups.
Startups can only sustain their innovation if they are fuelled by a good source of funding which lets them get a foothold in the market, start rolling out new features to expand and scale-up and grow to reach initial public offerings (IPO) or expand to international markets.
How Is A VC Fund Formed?
Venture capital (VC) is the funding raised by a startup in exchange for returns on the investment. Here, an investment firm is usually at the centre stage, and pools in the money from high net worth individuals or large enterprises looking to invest their capital into new businesses.
Wealthy individuals tend to depend on the credibility of the VC firm, so that their funds get properly managed and the investment generates maximum returns. Thus the track record of a venture capital firm is immensely important to attract investors to the fund.
Depending on the risk-taking nature of VC companies, funds, thus collected, are invested at various stages of a startup business. The stages of venture capital funding or series funding include early-stage (Series A funding), growth stage (Series B funding) and late-stage (Series C funding). To cash out the return, venture capitalists need to make a successful exit when the startup is at the stage of IPO or acquisition. Besides monetary help, venture capitalists also share expertise, offer related services or lend infrastructure to help a startup grow.
Structure Of A VC Firm
To have a clear idea of how a VC fund works, one first needs to understand the structure of a VC firm and its working process.
The topmost layer of a VC firm is formed by the individuals who pool in their money for funding. These people are termed as limited partners (LP), who are important to finalising deals with startups. Limited partners don’t interfere with how the fund is invested or the money is managed and earn returns from the money they had provided to the VC firm.
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Some of the key responsibilities of the general partners (GP) at a VC firm include management of money, investment decisions and strategising the business for portfolio startups. Partners earn fees for managing the venture capital fund, by smartly investing it to earn returns and profits after paying out returns to fund investors. GPs also get a share of the profit the VC firm makes after providing returns to LPs.
A VC company, thus, chooses a portfolio of startups of a specific sector and invests in them, after judging the business model and roadmap. To ensure good returns, the VC company also acquires rights in a startup’s business decisions.
VC Startup Funding Assessment
While market conditions, associated trends, business risks are among the most important questions that VCs seek to answer before investing, it often goes beyond that.
To gauge its capacity of earning returns, VCs undertake due diligence to assess a startup’s potential to yield return, on the basis of its business plan, products, current traction and growth strategy. Thorough research and audits are carried out on the business plan presented by the startup to estimate its revenues, future growth path of the business and profitability.
Moreover, the VC firm does a market study to get an idea of the startup’s credibility among customers, the track record of the founders and other data around the sector. If all goes well, the VC firm invests and gains position in the company’s board of directors to influence its business decisions and ensure profitability.
Challenges For VCs
No matter the amount of due diligence, there’s always some risk involved with investing in startups. There could be many points of failure that are out of the investor’s hands — such as regulatory changes, or a rushed business decision, lack of penetration in the market or competition doing better.
Simply put, venture capital funding involves a huge amount of risk given the high stakes and the high risk of incurring a loss as is often the case for many startups. Moreover, there can be external factors such as economic slowdown or liquidity crisis that can hugely impact the startup ecosystem as a whole.
Like every business, the ultimate goal of VCs is to earn profit from investing funds in startups. Usually, venture capital funds are invested for a period of 8-10 years, providing ample time for the startup to grow and earn returns. At the end of this period, as the startup or company matures to reach either the stage of IPO or becomes the target for large acquisitions, the venture capital firm usually makes an exit; cashing out their returns from the merger, acquisition or IPO deals by the startup.
LPs of the firm are paid returns on investment and the rest is the profit for the VC firm. Hence, to secure profit for themselves, VC firms calculate the required high return from the investment and keep pushing for business decisions that in their estimate might bring those results. In case, the business starts showing signs of failure, the VC firm can make an early exit too and attempt to cash out the money by selling its equity.
Going Beyond Funding
In order to back their investments, VCs go beyond just funding and support their portfolio’s growth efforts by offering expertise, market research and analysis, infrastructure and networking opportunities. These can come as a package included in the venture capital funding round.
These perks help a startup find itself in a better position in the market to face risks or avert them, thereby increasing chances of returns and profit for the VC itself. In addition, startups can often find synergies with other startups under a VC’s portfolio and these can have a positive impact on the growth and brand value of the startup.
And for startups that are exploring international markets, VC funding can not only bring the capital but also the market connections and knowhow to tackle overseas expansion.
Balancing Profits With Loss
The reality is that most startups fail. And this high probability of failure brings up the question of how VCs cope with losses. To protect their investment to a certain extent, venture capitalists charge management fees and carrying costs, which are additional to the big amount of returns they get from a successful exit.
Moreover, by the time a startup gets VC funding, it has already shown some traction and the investment strategy of the VC balances high-risk investments with investment in growth-stage companies that are more certain to bring returns. Like any other investment, venture capital companies need to hold a diversified portfolio.
With the digital revolution making a big impact in the Indian market, and as consumer preferences evolve, sectors such as ecommerce, hyperlocal delivery and consumer services have flourished. With the success of VC-backed startups in the Indian context, venture capital funding has become a major goal for startups.