Venture capital is a subset of private equity and a type of financing in which investors provide funds and financing to start-up companies and small businesses that are thought to have high long-term growth potential.
These early-stage and emerging companies that have been identified as having high growth potential or have demonstrated high growth have access to a pool of funds and investors. Understanding how Venture Capital works can be extremely beneficial to you, whether you are an entrepreneur or not.
Venture capital firms are without a doubt the muscle behind innovation as they support the company they may invest in, from the early stages, all the way to IPO — especially those with larger funds that have billions of dollars under management.
Myths And Misconceptions Around Venture Capital
What exactly is venture capital, and what are some common misconceptions about it? A common misconception about venture capital is that VCs do not typically fund start-ups from the beginning. Rather, most venture capitalists seek to invest in companies that are in the process of commercialising their ideas.
The venture capital fund will then invest in these companies, nurture their growth and development, and then look to cash out with a significant return on investment, a performance measure used to evaluate the efficiency of an investment that is typically calculated by dividing the benefit (meaning, return) of an investment by the costs of an investment.
It is important to note that, contrary to popular and public perception, venture capital plays only a minor role in funding basic innovation. In 1997, venture capitalists invested more than $10 billion USD, but only about 6%, or about 600 million USD, went to startups.
What’s In it For the Investor?
Venture capital firms or funds invest in these early high growth stage companies in exchange for equity or a stake in the company, and they are willing to take the risk of financing risky start-ups in the hope that some of the firms they support will succeed.
However, because start-ups face high uncertainty, VC investments typically fail at a high rate. Despite the risk, the possibility of above-average returns is an incentive and an appealing payoff for potential investors.
In recent decades, how venture capital works for new companies or ventures with a short and limited operating history has been that venture capital funding is increasingly becoming a popular, even expected, and essential source of capital, especially because a challenge for emerging companies is primarily a lack of access to capital markets, traditional lending institutions such as bank loans and other debt instruments.
The seed stage is the first round of official funding. This is the company's first source of funding. The funding from this stage, as the name implies, is like a seed planted in order to eventually see a flourishing garden. At this point, the company will require the funds to begin market research and product development. Then proceed to series A, Series A funding is used to ensure the continued growth of a business. It can be used to aid in product development and in procuring more talent to help grow the company. Before Series A funding is obtained the VC firm looking to invest will do due diligence and a valuation of the company. “The goals of valuation in series A fundraising include the identification and assessment of progress made by a company using its seed capital, as well as the efficiency of its management team. Additionally, the valuation process demonstrates how well a company and its management use the available resources to earn profits in the future.”
Series B funding comes in once the business has been launched and established, has started its operation, and proven its business model. In addition, securing Series B funding only comes in when the company has been generating stable revenues and has earned some profit. Series B funding is used to take the company to the next level by infusing the capital it has raised and putting it towards sales, marketing, talent acquisition, and developing new technologies.
“Series C funding is meant for companies that have already proven themselves as a business model but need more capital for expansion.” These companies are already quite successful, established, and growing. “At this point, the startup is no longer really a “startup,” but rather an established business with a proven business model, which needs to either expand its product offerings, expand into new markets, or expand its marketing output.”
Worst Things Might Happened
SoftBank said it was pulling back by 50-75% on start-up investments after it haemorrhaged billions on tech investments. Already start-ups were concerned they were being left to die by the firm, and now it’s confirmed the escape hatch is closed. Tiger Global lost $17 billion and has almost fully invested its latest fund. “If you owned growth stocks this year — like we did at Altimeter — you got your face ripped off,” Altimeter’s Brad Gerstner tweeted in a thread where he conceded the hedge fund did not hedge enough. Goldman Sachs is moving away from SPACs amid regulatory scrutiny. The ones that are on the market aren’t faring well either, with scooter start-up Bird’s stock dropping below a dollar for the first time this week. Crypto has possibly had it even worse, to the point that even Ryanair is roasting “crypto bros” on Twitter. Coinbase’s value has fallen nearly 80% since its direct listing last year and is now lower than where a lot of its late-stage investors bought in.
What does that mean for start-up’s? The firehose is drying up and that goes for both start-up’s and VCs alike when raising money. Venture capitalists have moved the goalposts. It’s not about how fast you move, it’s about how little capital it takes to get you there. With public comps destroyed and investors like SoftBank sitting on their hands, start-up’s and VCs have to re-run the numbers and not assume money will just materialize.
The lingering question as start-ups recalibrate is whether you believe Rabois that it’s June 2000 all over again. And if you do, is your worst-case scenario really worst-case enough? Right now, start-ups are facing a contraction in valuation — not revenue, which was the case in early COVID days in addition of the war economic recession. Public-market comps are down 60% or more in some sectors, and they tend to be the leading indicator of how VCs are similarly going to value startups down the road. That means startups are going to need more revenue to get back to their last valuations and enough runway (think 2.5 years instead of two) to get there.