Let’s start with the private capital which is the gamp term of the investments. Private capital is of the private investments encircling the private debt, real estate, natural resources, private equity, venture capital. It would be fair to say venture capital is a subset of private equity. We often confuse financial terms, as they always overlap and are way too complex to understand. One such place where we confuse ourselves is with different types of equity. For now, we will focus on venture capital. Venture capital is an investment in companies in their toddler stage. They invest in private (limited) companies. These companies are not listed in the stock market. Even though they have invested in a certain company there is no involvement in the company’s functioning. The term venture is due to the chances of imperil of the capital. This kind of equity in early-stage companies means giving money in good faith for a considerably long period of time. Therefore the term venture!
NEED FOR VENTURE CAPITAL
One may be wondering, banks exist for a reason. Banks lend a helping hand to those who have collaterals. They need property or some tangible assets(machinery, land) to grant a loan. In today’s digital and tech economies, it is hard to have the kind of assets the banks desire.
Even if they find a common ground the interest r ate of the banks is way too high for small start-ups.
This is where venture capital saves the day. Venture capital fills the gaps due to the loan system.
Another major reason for the thriving of the venture capital system is they do not grant a loan instead take responsibility. Even though the investor doesn’t meddle he/she gives valuable insights into the company. Whereas the bank only provides a certain amount of money.
HOW DOES VENTURE CAPITAL WORK
Where does the VC(venture capital) firm get its money from?
They work with General Partners and Limited Partners.
The limited partners in the sense those who invest but don’t meddle with the functioning of the firm. The people or firms funding the VC are also investing in them. They are insurance companies, wealthy families, and institutions that have large funds with them. Due to the nature of VCs taking high risks the investing companies only provide a small percentage of their funds. They generally give 6-10%.
The General Partners
They have multiple roles and jobs to balance. They are the core as they are responsible for raising funds, investing, growing, and the exit strategy.The general partners raise funds by reaching out to the Limited Partners. They have to pitch the idea of getting returns and convince them of being capable of getting higher returns than investing in debts, real estate, public equities. They have to prepare to balance and protect the downside of the risks. Venture capitals have a higher inclination for the preferred equity than the common equity. The preferred equity allows them to have higher security, by allowing them to sell off the assets and the tech in case of a total shutdown.To have control and a say in the company, they add a stipulation of voting rights on key decisions(selling the company or launching it to the stock market). They also add the stipulant for anti-dilution. All of these should bring in the limited partners to give their funding. Here is where the protagonist appears. They thoroughly research and evaluate the start-ups. And finally, they hand out a big fat check to the start-ups. Having capital to fund the startups is already fuel to them. But they help them grow, by providing any help they can use. It can be anything, helping with investors for the fundraising, handing them a blueprint, providing aptitude. After enough returns and an exponential growth phase the GP (General Partners) try out two things. Either try to sell the company or if one is not up for that, they try to make the company public. They sell it to another investor. This is known as the secondary sale. This is the time where they return the money to the Limited Partners.
The Limited partners grant a fund life of 8 to 10 years. The funds with interest must be returned at the end of it. All the jostling happens in these years.
>2-3 years, identification and investment in the startups take place
>4-5 years, they grow and stretch out.
>2 years, they plan and execute the retrieval and exit of the investments.
In terms of effort and time, VCs put in 10% time in canvassing the businesses. 3-5% for selecting, analyzing business plans, and negotiating the investment deals. They spend their majority of the time recruiting, consulting, monitoring, and directing the start-ups. After these things, 10% time is given to grooming and assisting outside relationships. 3% is given to exiting the companies.
VCs require analysts to do research and analyze the risk factor. A VC analyst is the strength of a VC firm. The crucial decision of investing depends on them.
HOW DO VENTURE CAPITAL FIRMS MAKE ACTUAL MONEY
For all these expenses to invest the funds of LPs, the GPs take a 2-3% of ‘management fee’. They take these every year. From there, they pay themselves and hire analysts and managing staff.
The above was the basic the GPs get paid to manage the wealth and funds of the LPs. There is a term carry scheme. Under this scheme, carry means the bonus paid to GPs to perform well. The profit from the minimum return promised is shared among the two parties. LPs get 70-75% and the rest goes to the GP.
In a Venture Capital(VC) firm the carry forms the larger part of the income.
A VC firm has many investments and many funds from different companies and agencies. Each has a different hurdling rate, varying fund life, and different theme of investment. All this is managed by the GP. All of this juggling helps a steady flow of income and funds.
VCs also make money from the returns of “ Power Law ”.
The Power law means not all investments have to be successful. 2 to 3 successes can contribute to the return of the entire fund. If some have failed that is zero value, then the exponential growth of others will still be a growth o f some percent. This is considered a success.
It means that the VC goes after companies that aim at 300% or higher growth in the next half-decade. Due to this VCs are bent in inline towards companies having large markets. Naturally, tech companies, health care a re bound to grow very fast.
There are too many variants in a basic deal.
Taking a typical example of any start-up. The venture capital will invest $4 million in exchange for a 40% preferred-equity ownership position and seal the deal to a start-up.
HOW THE START-UPS ARE AFFECTED
Venture Capital’s financing startup companies a nd small businesses give them an upthrust. This is an upthrust because the companies with potential suffer a resistance just due to lack of resources. Here investors providing funds are gambling that the newer company will deliver and will not deteriorate. However, the cut deal is potentially above-average returns if the company delivers on its potential. For newer companies or those with a short operating history—two years or less—venture capital funding is both popular and sometimes necessary for raising capital.
A downside for the fledgling company is that the investors often obtain equity in the company and, therefore, a voice in company decisions.
The upside for startups Companies funded by venture capitals attract a lot of talent. The scheme is quite appealing despite the risky nature of the job. A lot of new engineers and business-minded people for the jobs. The basic reason is learning and high prospects of growth. Climbing a corporate ladder has too many hurdles and competition.
A few famous examples are Integrated electronics as in intel. In 1968 Robert Noyce reached out to Arthur rock for a business loan. He gave him $2.5 million and three years later the company went public. Arthur got $8.2 million as a return. This is a 130% return. A similar deal was m ade with Apple and Arthur got a return o f 23000%. Here in India, we have a humongous market and thus a rise of VC firms too. A good VC firm makes around $5-8 million. A top-tier firm makes $10-20 million or even more.
Here are the top VC firms investing in the startups of India a nd their sectors.
Tiger Global – Technology-based Consumer Services
Sequoia Capital – Healthcare, Consumer Internet, Financial Sector
Kalaari Capital – ECommerce, Curated Web
Chiratae Ventures – Mobile, Engineering-Medical Devices, T echnology-based Consumer Services, Software Products
Accel Partners – Infrastructure, Mobile & Software, Internet and Consumer Services
Venture East – Digital Healthcare, Consumer-driven & Retail, Pharma & Life Sciences
There is the phenomenal growth of VC in India. They have expanded and generated great avenues for the startups and generated a great deal of return from them too. The future of a VC seems quite promising.
Indian companies have gained $10 billion in venture capital investments in 2020 and in 2019 the stats were around $11.1 billion.
When a company hits the $1 billion mark, it is called the unicorn company. India has more than 35 unicorn startups, around 11 of which were added in 2020 alone. India is raining Unicorns and will soon become a global unicorn hub. Not only t hat Industry experts have predicted that India will have 100 unicorns by 2025.
Digit Insurance became India’s first unicorn of 2021.
Jyoti Bansal’s Harness, a B2B startup, also raised $115M and attained unicorn status at a $1.7 billion valuation.