OfStartups

Tag: venture capital

  • How does venture capital work

    Venture capital is the investment made in high-growth potential startups and growing companies where regular banking institutions are shy of investing. The venture capital is on a broad level worked out in three processes.

    venture capital is the investment made in high-growth startups and growing companies

    Fundraising

    Venture capital firms are responsible for the end-to-end ownership of the funds. VC firms do not have the required funds within them. They get the funds that they want to invest by raising from various sources, primarily institutional investors and high-net-worth individuals. These entities from where they raise funds are called limited partners. Institutional investors are entities like insurance companies, endowment funds, and pension funds. High net worth individuals are the people who are wealthy individuals and are looking to invest their money.

    VC firms go through a fundraising process, where they pitch to potential investors showcasing their strategy, previous track records, and exits. They showcase the investment focus and have a target fund size. Different VC firms have different investment focus. It can be but is not limited to, sectors, geographies, or industries. This is similar to a startup raising money.

    The conclusion of the fundraising process is the limited partners committing a specific amount of money for a time period. This capital is given to the VC firm when an appropriate investment opportunity is recognized. This process is called capital calls.

    Fund management

    A typical VC firm has analysts, associates, and partners who consist of their investment team. An analyst supports the investment team with research, data analysis, and administrative tasks. An associate supports the investment team in sourcing deals, conducting market research, and performing due diligence on potential investments. A partner leads the investment and negotiates the deal with startups. A managing partner sets the overall strategy and is responsible for fundraising.

    A venture capital firm has a typical investment period. They invest in startups during this time according to their strategy of investment. After they have made the investment in a company they offer their expertise in various parts of a startup’s journey like marketing, development, and legal. For this active management and guidance to the investee companies, they have a whole network of experts in their fields.

    To manage these expenses, a VC firm charges a management fee for the operational expenses. This is typically a percentage of the committed capital. They also receive a carried interest which is a percentage of profits generated by the fund.

    Fund exits

    All the VC funds have their lifespan. Within this lifespan, they help with all the support for a company that is required for them to grow. A typical lifespan of a fund is about 10 years, after which the exits are expected. There are various types of exits that the VC fund makes from a startup like IPO, acquisition, or direct profits. While a startup raises funds from the VC, these potential exits are discussed, as it is an important part of the strategy. As the portfolio companies grow and mature, the way to plan exit for the VC starts.

    VC firms regularly demonstrate the progress of the fund to the investors. Reports and performance status of the fund’s progress are updated to the investors at a regular cadence. Once the investments are successful, they are distributed between the limited partners and the VC firms according to the agreed terms.

  • Business risks associated with early-stage startups

    Starting a business is not easy. 90% of the startups fail. Though there are a number of risks associated with a business, some risks are more common in the early days of a startup. Mitigating these risks can lead to a higher probability of the startup surviving.

    90% of startups fail

    Market risk

    When you build a product, what essentially means is that you are solving a pain point for your segment of the market. For this, you need to know your customers and the market in depth. What is the use of building a product that no one wants?

    Hence knowing your customers in-depth, their spending pattern, their needs, and the influencers in your customer segment is an important study to do before entering the market.

    Achieving the product-market fit is crucial to overcome this market risk.

    Financial risk

    Capital is the lifeline of any business. For new startups, where the capital available is limited, the risk associated with the drying up of the capital is high. Startups have to create well-articulated business plans with realistic financial milestones. There should be clear timelines with financial milestones of when the company would need more capital, and when would it be profitable.

    In the initial days, startups often go into negative cashflows. If this negative cash flow cycle stays for a very large amount of time, there is a risk of bankruptcy. When startups are relying too much on external funding, there is a risk involved when the funding dries up or investors back off. Similarly, financial risk can emerge from relying on limited customers or product lines. Diversification of customer types and product lines is a good way to mitigate it.

    Team risk

    Early-stage startups have limited resources. Hence it is important to make the best out of the limited resources available. In the initial days of a startup, the team is everything. Other than any other factor, it is only the founding team that matters the most. Products can change, markets can change, and strategies can change, but only if the founding team is strong and consistent enough to make anything for the survival of the company. A founding team with the right and complementary skills, ruthless execution, and high consistency & motivation is the key to success. In fact, investors bet on the founders, than the product in the early stages of a startup.

    Lack of complementary skills, lack of communication between the founding team, and cultural misfit possess a risk of failure in the early stages of a startup.

    Execution risk

    Everything boils down to execution. What is a great product idea without execution? Execution risks are the challenges involved in implementing the vision of the startup.

    Technical difficulties during product development might pose a risk of failure with delays in the release of the product. A startup’s reputation is highly risked if the customers using the product are not satisfied because of quality issues, and a lack of good customer support. Entering the market too early or too late can be a risk factor resulting in failure. Lack of adoption with respect to the changes in the markets can lead to detrimental effects on the startup. In case the product does not work, a lack of pivoting can lead to the startup failure.

  • What is Venture Capital?

    All the large corporations we see today have started small with disruptive and huge potential ideas. And it requires money to execute these ideas to manifest into the great products and companies that we see.

    Venture capital is a private equity that invests in emerging startup companies

    Venture Capital

    Venture capital is a private equity that invests in emerging startup companies. These startup companies may or may not have an operating history, but have a huge growth potential. High risk, high reward. Venture capital comes into play when traditional banking institutions, without a strong operating history, do not give loans.

    Venture Capital Firms

    Venture capital firms are companies that raise money from institutions or HNIs and invest in promising startups. They are composed of professional investors who have in-depth knowledge about building companies and funding them.

    Venture capital firms typically invest in high-growth startups for equity. They earn from the returns made by the investee company from profits or from exits. Nine out of ten startups fail, so the VC firm has to make sure that the returns made from that one successful startup cover the investment made in all.

    Benefits of venture capital

    1. Startups get the required capital to develop new products, scale their operations, hire talent, and expand the market. 
    2. This fund is without the obligation to return the capital which is the case for a loan. As VC typically funds against equity shares, all the stakeholders grow together. But in case of failure, there is no obligation to repay the startup.
    3. VC brings with them a powerful network that can be useful for getting new clients, as well as help in further investment rounds. VCs bring their experience in strategy, marketing, technology, and legal which is helpful for startups.
    4. Venture capital firms can help in collaboration with companies operating in similar domains to consolidate the market.
    5. Venture capital can help startups to make successful exits like mergers & acquisitions, IPOs, and further rounds of investments.

    The risk associated with venture capital

    1. Venture capital funding leads to a significant equity dilution in a startup and, hence, dilution in the control of the company to the founders. All the major decisions need to be approved by the board, unlike prior to the fundraiser when the founder has the freedom to make all the decisions.
    2. In cases where the founders and investors have a conflict of interest, conflicts can arise within the board which is a high risk for the company.
    3. Venture capital raising is a time-consuming and non-guarantee process. Startups may find it difficult to find the right balance between the continuation of operations and raising funds.

  • Startup funding winter: Blessing in disguise

    In 2021, the startup funding in India peaked at $37 billion. After this peak, however, it steeply decreased in the following time period. In the January to July 2023 period, the number was $4.4 billion. This reduction is due to the gloomy macroeconomic environment of the world. But the fact is startups are finding it hard to raise funds. But this is the right time to introspect for startups. This, in fact, is a blessing in disguise for the startup ecosystems.

    startup funding has drastically decreased from it's peak in 2021

    Profitability over growth

    Growth is good, but growth at any cost is certainly not. With the difficulty of accessing capital in the market, it is essential for startups to be having liquid cash, which comes from strong cash flows and profits. When the capital access is easy, “growth” is prioritized over the profits. Though this can work, it is a high-risk and high-reward game. With startups forced to focus on profits over growth, it results in good financial management and long-term success.

    Stronger business models

    Startups are forced to introspect on the current business models. If the current models are not working they must be changed. During difficult times, only the models with a clear roadmap towards profitability will be relevant. This will eventually lead to stronger and more sustainable companies.

    Innovation

    Necessity is the mother of all inventions. Building businesses in the limited availability of resources leads to innovations that can lead to advantages on the top line as well as the bottom line of a company.

    With a more competitive funding landscape, startups may be motivated to innovate more rigorously and differentiate themselves from the competition. This can lead to the development of more unique and impactful solutions. And this is a win-win for both – startups and customers. Also, innovation for cutting the cost of internal operations will ensure good margins.

    Market consolidation

    The funding winter can lead to partnering, and mergers & acquisitions of similar businesses, making the market positioning stronger in the competitive landscape. Also, with few startups getting investment, there can be less competition which can lead to fast capturing of the market for the sustainable and established startups. With the limited funding, investors may be compelled to invest in the companies that have proven traction and road to profitability. This would increase the investment in the companies which are more likely to be successful.

    Long term success

    All the above-mentioned factors will contribute to the long-term success of the startups. Those navigating the hard times will be winners. In history, it has been seen that successful companies often have emerged out of the worst economic conditions.