The Nobel Economist: Venture Capitalism is the Key

Venture Capitalism is the Key

A Venture Capitalist[1] is an investor who either provides capital to startup ventures or supports small companies that wish to expand but do not have access to equities markets. Venture capitalists are willing to invest in such companies because they can earn a massive return on their investments if these companies are a success. Venture Capital is the money that is provided by investors to startups that have the potential to reshape markets and grow very fast. The money deployed by a VC firm usually comes from institutional investors, corporations or wealthy individuals looking to make some serious dough.

Let us take an example of 2 entrepreneurs that have built a camera app that is getting a lot of customers and media attention. The banks are hesitant to lend them money since they think is too risky. But a successful VC (Venture Capitalist) looks at what the entrepreneurs have done and thinks the benefits outweigh the risks. He gets to know the business people, learns about the product, reads the business plan and finds out how much they’ve done so far. If the VC likes what he sees he decides to invest in the Start-Up. He does the same in varying amounts to other startups with similar potential. About 3 out of 4 startups fail, so a VC has to make sure the projects that do make money make enough of it to cover the losses of the failures. VC’s love tech startups because of their ability to scale easily. As for the money that the entrepreneurs will get, it depends on which stage they are at. Seed Funding is at the earliest stage. Series A is for when the company has established product and market fit started to make some serious buzz and it’s customer base is growing fast. Series B is when the company has started to make some considerable revenue in select markets and is looking to expand operations. Series C and onwards is when the company has grown up and is likely operating on a global scale. It might be ready for an IPO, to be bought by another company or continue operating as a private firm. IPO means the company goes public in the stock market, that is when the VC finally sees a nice return on his initial investment. Venture Capitalist is a high risk, high reward game that funds innovative ideas and keeps the tech world going.

Take a look at the following chart describing a Startup’s Financing Cycle:

The initial phase is known as the “Valley of Death”. Few Startups ever make it after that phase. That is the point where the first investments, known as “seed capital”, enter the business. This is why early investors are known as ANGEL INVESTORS[1]. They provide with a one-time investment to help the business propel or an ongoing injection of money to support and carry the company through in difficult early stages. They are often retired entrepreneurs or executives, who may be interested in angel investing for reasons that go beyond pure monetary return. These include wanting to keep abreast of current developments in a particular business arena, mentoring another generation of entrepreneurs, and making use of their experience and networks on a less than full-time basis. Angel Investments bear extremely high risks and are usually subject to dilution from future investment rounds and as such require very high return on investment. They usually seek investments that have the potential to return at least ten or more times their original investment within 5 years.

Once the business starts turning in a profit, the break-even point is reached. Venture Capitalists appear in the Early Stage of the business. Venture Capital is invested in exchange for an equity stake in the business. The return of the venture capitalist as a shareholder depends on the growth and profitability of the business. This return is generally earned when the venture capitalist “exits” by selling it’s shareholdings when the business is sold to another owner. Venture Capitalists look for qualities such as innovative technology, potential for rapid growth, a well-developed business model, and an impressive management team. Funds are most interested in ventures with exceptionally high growth potential, as only such opportunities are likely capable of providing financial returns and a successful exit within the required frame (typically 3-7 years) that venture capitalists expect. VCs are expected to nurture the companies in which they invest, in order to increase the likelihood of reaching an IPO stage when valuations are favorable. Venture Capitalists typically assist at four stages in the company’s development: Idea Generation; Start-Up; Ramp up; and Exit.

Financing Stages include: Seed funding (earliest to prove a new idea, often provided by angel investors); Start-Up (funding for expenses associated with marketing and product development); Growth (early sales and manufacturing costs: Series A, B, C and so on); Second-Round (working capital for early stage companies that are selling product, but no yet turning profit); Exit of venture capitalist (VCs can exit through secondary sale or an IPO or an acquisition. Early stage (VCs may exit in later rounds when new investors buy the shares of existing investors); Bridge Financing (funding between VC rounds, with the goal to raise smaller amount of money instead of a full round and usually the existing investors participate).

Initial Public Offering (IPO) is a public offering in which shares of a company usually are sold to institutional investors that in turn, sell to the general public, on a securities exchange, for the first time. Through this process, a privately held company transforms into a public company. Initial public offerings are mostly used by companies to raise the expansion of capital, or to monetize investments of early private investors. “Going public”, as this process is known has also some disadvantages, such as requirements to disclose certain information that could prove helpful to competitors. Consider that most companies do not really go public. The % of IPOs should be relatively small, compared to the full spectrum of existing businesses. Founded in February 2004, Facebook only went public in May 2012, constituting one of the biggest IPOs in Internet history, with a peak market capitalization of over USD 104 billion. The NASDAQ Index[2] is the second-largest in the world by market capitalization, behind only the New York Stock Exchange[3]. It is famous for hosting the largest tech companies in the World.

Being open and transparent is crucial to attract investment. Trust will be the major component of the relationship with the Venture Capitalist or Angel Investor. They will want to know all the details of your business plan, and will contribute to the overall strategy. They also have the right to require audits and transparent numbers, considering that they are the OWNERS of a share in your company. No matter how small that share is, they have the right to access full information.

Venture Capitalism is associated with JOB creation (accounting for 2% of US GDP) and the knowledge economy. Every year 2 million businesses are created in the US, and 600-800 get venture capital funding. 11% of private sector jobs come from venture-backed companies and venture-backed revenue accounts for 21% of US GDP. Financing is of course KEY to development. Whereas developed countries usually have easy access to funding, developing countries could struggle attracting international funds. Ranking high in the Corruption Perception Index[4] (CPI) will also help YOUR company scale internationally. The business culture you belong to will inspire more, or less TRUST. However, no mountain is too high to climb. It is up to YOU and only YOU to succeed… or NOT!