Financial Services: Venture Capital | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

• Entrepreneurs often require capital to kickstart their start-up companies. This capital, provided by affluent investors, is known as Venture Capital, and the investors are referred to as Venture Capitalists.
• VC firms mitigate investment risks by co-investing with other VC firms. Usually, there is a main investor, known as the 'lead investor', while the other investors are referred to as 'followers'.

How does a Venture Capital Fund operate?

• A Venture Capital Fund comprises investments from affluent individuals or companies, who entrust their funds to a VC firm for portfolio management and investment in high-risk start-ups in exchange for equity.
• The fundamental concept is to invest in a company's financial health and infrastructure.
• Venture Capitalists nurture an entrepreneur's idea for a limited period and exit with the assistance of an investment banker.
• In a start-up company, VCs receive an equity partnership in return for their investments.
• VCs are granted liquidation preference, meaning that in the worst-case scenario where the company fails, VCs are prioritized for all the company's assets and technology. This also grants them voting rights over crucial decisions such as Initial Public Offer (IPO) or the sale of the company.

What are the types of Venture Capital funding?

Depending on the ideation stage, age of the start-up company, and its performance over the years, Venture Capital funding can be classified into various categories.

• Pre-seed funding: Pre-seed funding typically ranges from $100,000 to $200,000 and is targeted at startups less than a year old. This funding aims to support research and development, market research, and team expansion.
• Seed Capital: Seed capital, ranging from $1 million to $2 million, is for startups that have a viable product and are aiming to enter the market.
• Series A funding: Series A funding, ranging from $2 million to $15 million, is provided to startups with a proven product that can support rapid scaling.
• Series B funding: Series B funding, ranging from $7 million to $20 million, is considered less risky and is used for business development and advertising.
• Series C funding: Series C funding, which typically amounts to around $25 million, is allocated for developing additional products and services or acquiring other companies.
• Series D funding: Series D funding is rare, and few startups reach this stage. Positive reasons for seeking Series D funding include the desire to remain private for longer or to expand further before going public. Negative reasons may involve not meeting expected growth plans, leading to a decrease in trust and a potential down round of funding.

Each letter corresponds to the development stage of the startup that has received funding.

What are the benefits of Venture Capital?

In an information-driven economy, startups often lack tangible assets, making it challenging for them to secure traditional bank financing. Venture Capitalists step in under these circumstances.

• Venture Capitalists offer valuable market insights.
• They assist in strategy formulation.
• They also help build strategic networks.

How is a Venture Capital (VC) Fund Structured?

• The current VC fund structure is akin to that of 40 to 50 years ago.
• The partnership comprises limited and general partners.
• The fund's duration ranges from 7 to 10 years.
• VC fund investments occur over the first two to three years, with returns typically realized over the last two or three years.
• Today, the average fund size and the number of managed investments are significantly higher than in the past.

Discuss the significance of Venture Capital.

• The Venture Capital industry in the USA is widely regarded as an economic growth catalyst. The modern-day computer industry in the USA was partly forged due to the capital made available by early venture capitalists such as Tom Perkins, Tommy Davis, Eugene Kleiner, and Arthur Rock.
• Innovation and entrepreneurship are the cornerstones of a capitalist economy. Yet, new businesses are often highly risky and capital-intensive endeavors. Therefore, external capital is often sought to diversify the risk of failure. In exchange for assuming this risk through investment, investors in new companies can obtain equity and voting rights for cents on the potential dollar. Venture capital thus enables startups to take flight and founders to realize their vision.

How do Venture Capital firms operate?

• Venture capital funds usually target a specific industry during a particular time period. For instance, in the 1980s in the US, Venture Capital (VC) funds primarily focused on the energy industry. Later, the focus shifted to genetic engineering, the telecom industry, and software companies. In the subsequent phase, VC funds turned their attention more toward Internet-based industries.
• One can safely conclude that VC funding is more influenced by the growth potential in a specific industry than by the potential and skills of individual entrepreneurs.

How does Venture Capital differ from an angel investor?

• While both provide funding to startups, venture capitalists are typically professional investors who invest in a diverse portfolio of new companies. They provide hands-on guidance and leverage their professional networks to assist the new firm. 
• On the other hand, angel investors are usually wealthy individuals who invest in new companies more as a hobby or side-project and may not offer the same level of expert guidance. Angel investors also tend to invest first, often followed by VCs.

What distinguishes venture capital from private equity?

• Venture capital is a subset of private equity. In addition to VC, private equity also encompasses leveraged buyouts, mezzanine financing, and private placements.