Venture Capital Financing and its process

Venture capital financing is a type of financing by venture capitalist: the type of private equity capital is provided as seed funding to early-stage, high-potential, growth companies and more often after the seed funding round as growth funding round (also referred as series A round) in the interest of generating a return through an eventual realization event such as an IPO or trade sale of the company.

To start a new startup company or to bring a new product to the market, the venture may need to attract financial funding. There are several categories of financing possibilities. If it is a small venture, then perhaps the venture can rely on family funding, loans from friends, personal bank loans or crowd funding.

For more ambitious projects, some companies need more than what mentioned above, some ventures have access to rare funding resources called Angel investors. These are private investors who are using their own capital to finance a ventures’ need. The Harvard report by William R. Kerr, Josh Lerner, and Antoinette Schoar tables evidence that angel-funded startup companies are less likely to fail than companies that rely on other forms of initial financing. Apart from these investors, there are also venture capitalist firms (VC-firms) who are specialized in financing new ventures against a lucrative return.

When a venture approaches the last one, the venture is going to do more than negotiating about the financial terms. Apart from the financial resources these firms are offering; the VC-firm also provides potential expertise the venture is lacking, such as legal or marketing knowledge. This is also known as Smart Money.

Venture Capital Financing Process

in general, the venture capital financing process can be distinguished into five stages;

1. The Seed stage
2. The Start-up stage
3. The Second stage
4. The Third stage
5. The Bridge/Pre-public stage

Of course the stages can be extended by as many stages as the VC-firm thinks it should be needed, which is done in practice all the time. This is done when the venture did not perform as the VC-firm expected. This is generally caused by bad management or because the market collapsed or a bit of both (see: Dot com boom). The next paragraphs will go into more details about each stage.

The following schematics shown here are called the process data models. All activities that find place in the venture capital financing process are displayed at the left side of the model. Each box stands for a stage of the process and each stage has a number of activities.

The Seed Stage

This is where the seed funding takes place. It is considered as the setup stage where a person or a venture approaches an angel investor or an investor in a VC-firm for funding for their idea/product. During this stage, the person or venture has to convince the investor why the idea/product is worthwhile. The investor will investigate into the technical and the economical feasibility (Feasibility Study) of the idea. In some cases, there is some sort of prototype of the idea/product that is not fully developed or tested.

If the idea is not feasible at this stage, and the investor does not see any potential in the idea/product, the investor will not consider financing the idea. However if the idea/product is not directly feasible, but part of the idea is worth for more investigation, the investor may invest some time and money in it for further investigation.

Example

A Dutch venture named High 5 Business Solution V.O.F. wants to develop a portal which allows companies to order lunch. To open this portal, the venture needs some financial resources, they also need marketers and market researchers to investigate whether there is a market for their idea. To attract these financial and non-financial resources, the executives of the venture decide to approach ABN AMRO Bank to see if the bank is interested in their idea.

After a few meetings, the executives are successful in convincing the bank to take a look in the feasibility of the idea. ABN AMRO decides to put a few experts for investigation. After two weeks time, the bank decides to invest. They come to an agreement of investigate a small amount of money into the venture. The bank also decides to provide a small team of marketers and market researchers and a supervisor. This is done to help the venture with the realization of their idea and to monitor the activities in the venture.

Risk

At this stage, the risk of losing the investment is tremendously high, because there are so many uncertain factors. From research, we know that the risk of losing the investment for the VC-firm is around the 66.2% and the causation of major risk by stage of development is 72%. These percentages are based on the research done by Ruhnka, J.C. and Young, J.E.

The Start-up Stage

If the idea/product/process is qualified for further investigation and/or investment, the process will go to the second stage; this is also called the start-up stage. At this point many exciting things happen. A business plan is presented by the attendant of the venture to the VC-firm. A management team is being formed to run the venture. If the company has a board of directors, a person from the VC-firms will take seats at the board of directors.

While the organization is being set up, the idea/product gets its form. The prototype is being developed and fully tested. In some cases, clients are being attracted for initial sales. The management-team establishes a feasible production line to produce the product. The VC-firm monitors the feasibility of the product and the capability of the management-team from the Board of directors.

To prove that the assumptions of the investors are correct about the investment, the VC-firm wants to see result of market research to see whether the market size is big enough, if there are enough consumers to buy their product. They also want to create a realistic forecast of the investment needed to push the venture into the next stage. If at this stage, the VC-firm is not satisfied about the progress or result from market research, the VC-firm may stop their funding and the venture will have to search for another investor(s). When the cause relies on handling of the management in charge, they will recommend replacing (parts of) the management team.

Example

Now the venture has attracted an investor, the venture need to satisfy the investor for further investment. To do that, the venture needs to provide the investor a clear business plan how to realize their idea and how the venture is planning to earn back the investment that is put into the venture, of course with a lucrative return.

Together with the market researchers, provided by the investor, the venture has to determine how big the market is in their region. They have to find out who are the potential clients and if the market is big enough to realize the idea.

From market research, the venture comes to know that there are enough potential clients for their portal site. But there are no providers of lunches yet. To convince these providers, the venture decided to do interviews with providers and try to convince them to join.

With this knowledge, the venture can finish their business plan and determine a pretty good forecast of the revenue, the cost of developing and maintaining the site and the profit the venture will earn in the following five years.

After reading the business plan and consulting the person who monitors the venture activities, the investor decides that the idea is worth for further development.

Risk

At this stage, the risk of losing the investment is shrinking, because the uncertainty is becoming clearer. The risk of losing the investment for the VC-firm is dropped to 53.0%, but the causation of major risk by stage of development becomes higher, which is 75.8%. This can be explained by the fact because the prototype was not fully developed and tested at the seed stage. And the VC-firm has underestimated the risk involved. Or it could be that the product and the purpose of the product have been changed during the development.

The Second Stage

At this stage, we presume that the idea has been transformed into a product and is being produced and sold. This is the first encounter with the rest of the market, the competitors. The venture is trying to squeeze between the rest and it tries to get some market share from the competitors. This is one of the main goals at this stage. Another important point is the cost. The venture is trying to minimize their losses in order to reach the break-even.

The management-team has to handle very decisively. The VC-firm monitors the management capability of the team. This consists of how the management-team manages the development process of the product and how they react to competition.

If at this stage the management-team is proven their capability of standing hold against the competition, the VC-firm will probably give a go for the next stage. However, if the management team lacks in managing the company or does not succeed in competing with the competitors, the VC-firm may suggest for restructuring of the management team and extend the stage by redoing the stage again. In case the venture is doing tremendously bad whether it is caused by the management team or from competition, the venture will cut the funding.

Example

The portal site needs to be developed. (If possible, the development should be taken place in house. If not, the venture needs to find a reliable designer to develop the site.) Developing the site in house is not possible; the venture does not have this knowledge in house. The venture decides to consult this with the investor. After a few meetings, the investor decides to provide the venture a small team of web-designers. The investor also has given the venture a deadline when the portal should be operational. The deadline is in 3 months.

In the meantime, the venture needs to produce a client-portfolio, who will provide their menu at the launch of the portal site. The venture also needs to come to an agreement how these providers are being promoted at the portal site and against what price.

After 3 months, the investor requests the status of development. Unfortunately for the venture, the development did not go as planned. The venture did not make the deadline. According to the one who is monitoring the activities, this is caused by the lack of decisiveness by the venture and the lack of skills of the designers.

The investor decides to cut back their financial investment after a long meeting. The venture is given another 3 months to come up with an operational portal site. Three designers are being replaced by a new designer and a consultant is attracted to support the executives’ decisions. If the venture does not make this deadline in time, they have to find another investor.

Luckily for the venture, with the come of the new designer and the consultant, the venture succeeds in making the deadline. They even have 2 weeks left before the second deadline ends.

Risk

At this stage, the risk of losing the investment still drops, because the venture is capable to estimate the risk. The risk of losing the investment for the VC-firm drops from 53.0% to 33.7%, and the causation of major risk by stage of development also drops at this stage, from 75.8% to 53.0%. This can be explained by the fact that there is not much developing going on at this stage. The venture is concentrated in promoting and selling the product. That is why the risk decreases.

The Third Stage

This stage is seen as the expansion/maturity phase of the previous stage. The venture tries to expand the market share they gained in the previous stage. This can be done by selling more amount of the product and having a good marketing campaign. Also, the venture will have to see whether it is possible to cut down their production cost or restructure the internal process. This can become more visible by doing a SWOT analysis. It is used to figure out the strength, weakness, opportunity and the threat the venture is facing and how to deal with it.

Except that the venture is expanding, the venture also starts to investigate follow-up products and services. In some cases, the venture also investigates how to expand the life-cycle of the existing product/service.

At this stage the VC-firm monitors the objectives already mentioned in the second stage and also the new objective mentioned at this stage. The VC-firm will evaluate if the management-team has made the expected reduction cost. They also want to know how the venture competes against the competitors. The new developed follow-up product will be evaluated to see if there is any potential.

Example

Finally the portal site is operational. The portal is getting more orders from the working class every day. To keep this going, the venture needs to promote their portal site. The venture decides to advertise by distributing flyers at each office in their region to attract new clients.

In the meanwhile, a small team is being assembled for sales, which will be responsible for getting new lunchrooms/bakeries, any eating-places in other cities/region to join the portal site. This way the venture also works on expanding their market.

Because of the delay at the previous stage, the venture did not fulfill the expected target. From a new forecast, requested by the investor, the venture expects to fulfill the target in the next quarter or the next half year. This is caused by external issues the venture does not have control of it. The venture has already suggested to stabilize the existing market the venture already owns and to decrease the promotion by 20% of what the venture is spending at the moment. This is approved by the investor.

Risk

At this stage, the risk of losing the investment for the VC-firm drops with 13.6% to 20.1%, and the causation of major risk by stage of development drops almost by half from 53.0% to 37.0%. However at this stage it happens often that new follow-up products are being developed. The risk of losing the investment is still decreasing. This may because the venture rely its income on the existing product. That is why the percentage continuous drop.

The Bridge/Pre-public Stage

In general this stage is the last stage of the venture capital financing process. The main goal of this stage is to achieve an exit vehicle for the investors and for the venture to go public. At this stage the venture achieves a certain amount of the market share. This gives the venture some opportunities like for example:

• Hostile take over
• Merger with other companies;
• Keeping away new competitors from approaching the market;
• Eliminate competitors.

Internally, the venture has to reposition the product and see where the product is positioned and if it is possible to attract new Market segmentation. This is also the phase to introduce the follow-up product/services to attract new clients and markets.

As we already mentioned, this is the final stage of the process. But most of the time, there will be an additional continuation stage involved between the third stage and the Bridge/pre-public stage. However there are limited circumstances known where investors made a very successful initial market impact might be able to move from the third stage directly to the exit stage. Most of the time the venture fails to achieves some of the important benchmarks the VC-firms aimed.

Example

Now the site is running smoothly, the venture is thinking about taking over the competitors’ website happen.nl. The site is promoting restaurants and is also doing business in online ordering food. This proposal is being protested by the investor, because it may cost a lot of the ventures’ capital. The investor suggests a merge instead.

To settle down their differences, the venture requested an external party to investigate into the case. The result of the investigation was a take-over. After reading the investigation, the investor agrees to it and happen.nl is being taken over by the venture. With the take-over of a competitor, the venture has expanded its services.

Seeing the ventures’ result, the investor comes to the conclusion that the venture still have not reach the target that was expected, but seeing how the business is progressing, the investor decides to extend its investment for another year.

Risk

At this final stage, the risk of losing the investment still exists. However, compared with the numbers mentioned at the seed-stage it is far lower. The risk of losing the investment the final stage is a little higher at 20.9%. This is caused by the number of times the VC-firms may want to expand the financing cycle, not to mention that the VC-firm is faced with a dilemma of whether to continuously invest or not. The causation of major risk by this stage of development is 33%. This is caused by the follow-up product that is introduced.

At Last

As mentioned in the first paragraph, a VC-firm is not only about funding and lucrative returns, but it offers also the non-funding issues like knowledge as well as for internal as for external issues. Also what we see here the further the process goes, the less risk of losing investment the VC-firm is risking.