By Kathleen Wang
What is venture capital?
Venture capital (VC) is a form of financing provided to emerging or early-stage companies with high growth potential. This capital is usually provided by investors in VC funds, in exchange for a stake in the ownership of the company.
Once the company grows to a certain size, the investors will exit the company (and gain a profit) by selling their stake through a merger, acquisition, or IPO. Investors will normally exit between five to seven years after the initial investment.
Who is involved?
There are usually four main actors involved in a VC transaction.
The entrepreneur – these are the start-up/emerging companies who require funding. These companies are typically pre-revenue (pursuing an idea/product but not yet generating significant revenue) although venture capital investments may come in at various stages of the company’s growth. These companies typically operate in high growth and high technology industries, such as IT, clean technology, or biotechnology.
In the past, VC-backed companies have included WhatsApp (sold to Facebook in 2014), Snapchat (went public in 2017), and Twitter (went public in 2013).
The investor – these are the people who provide the investment funds. These investors commonly include large corporations, pension funds, university endowments, or wealthy individuals (‘angel investors’). The investment funds are pooled into a VC fund, and the investors are considered limited partners in the fund (so called because their liability is limited and does not extend to general liability for the fund).
The VC fund – VC funds/firms act as the lynchpin between the company and the investor. VC funds are responsible for identifying and attracting promising companies, acquiring funds, and managing the investments (including allocating additional funds, monitoring the company growth process, and navigating exit options).
Investment banks – investment banks become relevant in the exit stage of the process, where the investment companies are ready to be sold. Investment banks help facilitate the sale process.
Benefits and Risks of VC Investments
For the investor – the nature of venture capital investments is high-risk; by investing in startups/emerging companies, and especially in the innovation and technology fields, investors are gambling on the success of a company at a stage where there might be no comparable precedents, or where it is still too early to differentiate between potentially successful companies from the others.
However, this risk is matched by potential high returns. VC investors can typically own a significant portion of the equity ownership of the company, which means significant profits if that company is later acquired or undergoes an IPO. For example, Sequoia Capital, the only venture investor for WhatsApp, turned its US$60 million investment into a profit of US$3 billion on the app’s acquisition by Facebook in 2014.
For the investment company – these companies can benefit significantly from a venture capital investment. As these companies are still emerging and may have limited operating histories, they may not be able to access other traditional sources of funding (such as bank loans) or in the amount needed. Venture capital investments provide for (potentially large) sources of funding, and which may occur in multiple rounds.
The biggest disadvantage is loss of control of the company. Because of the large stakes in ownership given to VC investors in exchange for funding, the company founders inevitably dilute their equity. This dilution consequently affects their say in the direction, management, and operation of the company.
Timeline of the VC Financing Process
There are typically five stages in the VC financing process:
Identifying an investment – Firstly, a VC fund will scope out potential high-growth companies to invest in. This involves a comprehensive due diligence process, including a thorough investigation of the company's business model, proposed product/service, management board, and operating history, among other things. The VC fund may also determine which companies to invest in by assessing the company’s likely value at the time of sale.
The initial investment – Once due diligence has been completed, the firm or the investor will pledge an investment of capital in exchange for equity in the company.
The majority of VC investments occur in the adolescent phase of a company’s life cycle – this is known as a Series A investment round. Specifically, this means that the capital is typically used to building the infrastructure required to grow the business (such as marketing, manufacturing, and sales)
Active monitoring – The firm or investor will then typically take an active role in the funded company, advising and monitoring its progress.
Subsequent investments – depending on the growth of the company, the VC firm/investor may provide additional capital; these are Series B (C, etc) investment rounds. The capital provided here may be used to assist companies that are selling their products but not yet turning a profit, or for a company at a newly profitable stage.
VC firms may also make a profit from this stage, by collecting management fees (typically around 2% of the capital under management), and a percentage of the profits of the company (anywhere between 20-25%).
Exit – After 5-7 years, VC investors can exit through a secondary sale, IPO, or an acquisition. Early stage VCs may also exit in later rounds when new investors buy the shares of existing investors. This is where VC investors collect the bulk of their returns.
Managing risks in a venture capital transaction
Because of the high risk associated with VC investments, there are several ways VC investors can mitigate risk in both the VC transaction structure and the transaction itself.
Joint financing – typically, a VC firm will not finance an individual company entirely by itself. Rather, they may work with other VC firm to finance the company, thereby distributing the risk.
Staggered financing – As seen above, most VC capital is not invested all at once initially, but can take place throughout multiple rounds. This structure allows the VC firm to advise the company and monitor its progress before releasing additional funds.
Antidilution clauses – these clauses in a transaction agreement protect against equity dilution if subsequent rounds of financing by other investors take place. If such financing is to take place, the VC firm will be given enough shares to maintain its original percentage of equity owned. This is important, as the main source of return for VC firms will be on the disposal of their percentage ownership.
Upside provisions – these provisions are useful if the funded company is doing well. Upside provisions give investors the right to invest additional money at a predetermined price. This means that investors can increase their stakes in the company at below market prices.
Formation of the second-largest venture capital fund – (June 2020) Addition, a new venture capital fund, is close to raising US$1.3 bn to invest in tech start-ups, despite the uncertainties surrounding the pandemic. This fund will be second-largest first-time venture capital fund of the century, behind only a $1.35bn fund raised in 2018.
Blackstone invests $200 million in Oatly – (July 2020) The Growth Fund of The Blackstone Group has invested $200 million in the plant-based alternative company. Although not in the technology sectors, Oatly and similar investments represent an emerging pattern in investor support for innovation around food production and sustainable food systems. Blackstone’s investment could represent the Group’s fund pivot towards growth companies, one in which there is little technology risk and where the company can benefit from Blackstone’s existing logistics and supply chain companies.
Sony backs Fortnite maker Epic Games with $250 million investment – (July 2020) With this investment, Sony gains a minority stake in the game developer company. Epic Games is behind the operation of many of the world’s most popular games (such as Fortnite and Gears of War), and the company’s game-engine software is often regarded as revolutionary digital entertainment technology. This investment is an example of corporate VC in a late-stage company; Epic Games has already raised US$1.5bn in three previous funding rounds, and the company is currently valued at US$17.86 bn. Sony’s investment comes ahead of the release of its PlayStation 5 Console, in competition with Microsoft’s upcoming Xbox.