What is Venture Capital?
In the past two blogs of the venture capital series, we went through the history of VC from a global and Indian standpoint. But what exactly is Venture Capital (VC)?
Quite simply put, venture capital is a type of private equity that is focused on early-stage companies called startups. And the need for this type of capital came into being because banks and conventional financial institutions are risk-averse. They hesitate to and rarely underwrite loans to businesses early in their lifecycle.
But like any business, and even more so in early-stage business, capital availability in debt or equity is important. Specifically, in early-stage businesses, the promoters rarely have enough capital surplus to suffice business needs. This is why private equity provides financing to early-stage, high-potential startups with the expectation of significant returns on investment. Venture capital thrives on these high-risk, high-reward investments and spends time supporting startups during their critical formative stages.
The VC ecosystem has three key players – limited partners (LPs) or the investors of the venture capital firms, venture capital firms (VCs) themselves, and entrepreneurs or startups seeking funding. However, over the past few years, the number of startups and VCs has exponentially increased. This has led to the addition of new stakeholders, such as incubators, accelerators, and centers of excellence – all of which are startup enablers, providing founders with additional reinforcements with skills and capability to build and hone the product and service they are building.
VC investments happen at various scales and stages of a company – and are named accordingly. While the funding rounds are called with various notations that keep changing with the market sentiment (For example, seed stage investments, Series A, B, C, D, and so on), the simpler categorization is – early stage, growth stage, and late stage investments.
And before I forget – all the investments in companies are in return for preference shares of the company. This is slightly different from common equity shares in that the preference shares come with a few preferential rights that protect the investments and incentivize the investors to take the risk that we spoke about earlier. Without these additional riders, the investors would ideally not be motivated to invest and stay invested for the long term. We will touch upon some of the important and well-known rights that come along with preference shares in the next few blogs in this series.
To end this blog, know that once invested, VCs usually have a 7-8-year timeline for exiting and realizing returns. This has slightly prolonged to around 10-12 years as we speak about this in 2023. The availability of private capital over the past few years has made it easier for companies to stay private for longer. It hence reflects in the preference of VCs to stay invested slightly longer and capture more value for investors of the VC funds themselves. At this stage, you must wonder how returns/IRR work for VC funds and investors. We will write about that in the next blog.
This is the third post by Dinesh Pai in the Venture Capital category. Dinesh heads investments for Rainmatter and is an avid blogger.
