Venture capital has grown up to be an integral element in the current business environment. It plunges into the bedrock of innovation and becomes the impetus of growth within economies. For many startup and high-growth companies, venture capital is that key source of funds enabling realization of rather ambitious ideas. But what is a venture capital process, and how does it actually work?
The article will look at the entire venture capital process in close detail; we will discuss all points from the pitch to the exit and promises to provide a great insight for entrepreneurs, investors, and anyone curious about the world of start-up financing. By the end of this guide, you’ll have a rather very detailed idea of how venture capital works and what it takes to raise such financing.
- About Venture Capital
To elaborate on this process, I believe it will be first necessary to try to understand what exactly is meant by venture capital and why it is so important.
Venture capital is best defined as private equity financing provided by a firm or a fund to entrepreneurial ventures, or small businesses with high growth potential. It typically involves financing in exchange for an equity stake in the business—the venture capital firms taking a bet on the entrepreneurial vision.
What is more, unlike traditional bank loans, there is no obligation to repay the amount that is invested. To get their return on investment, VCs look for times when the company will have a double-digit increment in growth, either when they get public or when they get acquired. This model of high-risk, high-reward has been the path to funding many of today’s tech giants, including Google, Facebook, and Uber.
- An Overview of the Venture Capital Process
The venture capital process encompasses the following main stages:
- Deal Sourcing and Screening
- Due Diligence
- Term Sheet Negotiation
- Investment
- Post-Investment Support
- Exit
Terminal
Of course, we must study all these processes in detail.
- Deal Sourcing and Screening
The venture capital process starts with deal sourcing and screening. This is a process by which VC firms come across potential investment opportunities.
3.1 Sourcing Deals
Deals are sourced by the VC firm from a variety of sources. They might include the following:
Network referrals: A sizeable number of deals come from its professional network–other fellow investors, entrepreneurs, or other industry contacts.
- Inbound pitches: VC firms may receive approaches from startups with their business plans.
- Proactive outreach: VC firms often reach out very aggressively in areas of their interest to scout around for good prospects.
- Accelerators and incubators: These can be some very good sources of early-stage startups.
- Industry events and conferences where VCs participate in networking and finding new opportunities
3.2 Initial Screening
Initial screening happens when the potential deals have been identified. The process includes reviewing the business plan of the startup, market opportunity, and assessment of the various capabilities of the team. On the leveled basic kind, this screening process considers the following:
Market size and its growth potential
Unique value proposition
Competitive advantage
Team experience and track record
Financial projections and capital needs
Most deals never make it past this point. Less than 1% of the opportunities brought to a VC’s attention typically get funded.
- Due Diligence
If a startup passes the screen, then the VC firm will move on to undertake due diligence. It is an in-depth probing of the company to substantiate the claims made and inspect its prospects.
4.1 Business Due Diligence
This will be done in understanding the underlying business model along with the market and competitive landscape the company operates in. VCs would:
Have a deeper look into the product or service offering of the company
Evaluate the size of the market and the growth potential of the same
Understand and examine the competitive landscape with its research
Examine the go-to-market strategy followed by the company
Understand the current traction and metrics of the company
4.2 Financial Due Diligence
This will give VCs a preview of the financial health of the company and projections going forward:
Review historical financials, if available
The financial projections need to be reviewed for assumptions
- Review the cash-burn and runway of the company
- Check the proposed use of funds
4.3 Legal Due Diligence
Concerns the structure of the company and potential issues with law:
Review corporate documents
Review of intellectual property rights
Pending litigation
Check regulatory compliance
4.4 Technical Due Diligence
Here, VCs will bring in some experts on the technicality of technology start-ups so that they will get to the view of the technology :
- The capability of the technology
Following are considered to be following factors while considering the worth of the investment:
Development roadmap
Capability of the technical team
- Term Sheet Negotiation
Upon satisfactory diligence, the VC offer’s a term sheet to the startup. This is a non-binding document by the VC, which is just an outline of the simple terms and conditions of the investment by the VC.
5.1 Key Terms in a Term Sheet
Valuation: The value of the company agreed upon by both parties
Investment amount: The amount the VC firm would contribute as an
- Equity stake: Percentage of the company the VC gets
- Liquidation preference: Specifies how proceeds are to be divided upon sale or liquidation
- Board seats: Number of board seats the VC gets
- Anti-dilution protection: Protects the ownership percentage of VCs during later rounds
- Voting rights: Entitles the VC to voting power in main decisions regarding the company
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5.2 Negotiation Process
Negotiating a term sheet can be a complex process, and it may go back and forth between the startup and the VC firm. Some of the most common terms negotiated include:
- Valuation: Startups generally want to drive up the valuation as much as possible, while VCs try to keep the price low.
- Board control: Founders usually want to try to hold onto board control.
- Liquidation preferences: Significant in the return of founders during exit
It’s critical that startups understand the implications of each term and that legal advice is obtained through the process.
- Investment
Agreement on the term sheet is followed by an investment. Steps to finalize an investment include:
6.1 Definitive Agreements
The lawyers for both sides will prepare and review final legal documents that have been generated. These usually include:
- Stock Purchase Agreement
- Investor Rights Agreement
- Voting Agreement
- Right of First Refusal and Co-Sale Agreement
- Amended and Restated Certificate of Incorporation
6.2 Closing
Once all documents are signed, the VC firm will wire the money to the startup and the transaction will be closed.
- Post Investment Support
The venture capital process doesn’t end once the cheque is written. Most VC firms have ongoing support to help their portfolio companies to be successful.
7.1 Board Participation
VCs generally take board seats in their portfolio companies. This allows them to:
Provide strategic guidance
- Key recruitment decisions
- Fundraising Assist
- Staying apprised of company progress
7.2 Operational Support
Most of the VCs offer operational support to their portfolio companies in one or more of the following aspects only:
- Recruitment: Participate in recruiting key employees
- Customer/Partner Introductions: Provid leads for customer or potential partner leads
- Strategy for Financial Planning: Offering ideas to the company on how to manage the finances and implement its strategy
- Network of Experts and Advisors: expose the company’s entrepreneurs to the VCs’ informal network of experts and advisors
7.3 Follow-on Funding
If a portfolio company has been successful, the VCs will generally participate in vas per:
They include:
-Follow-on funding rounds
-Take an active role in attracting new investors in bigger rounds
- Exit
The final stage in the venture capital process is the exit. At this point, the VC firm, together with the other shareholders, sells its stakes in the firm, which mainly happens through either of the two ways:
8.1 Initial Public Offering (IPO)
In an IPO, a company lists its shares on a public stock exchange. This allows the VC firm to sell to public market investors. IPOs can generate significant returns but are relatively infrequent.
8.2 Acquisition
More frequently, VC-backed companies are acquired by larger entities. The acquirer purchases the available shares, satisfying the return to the VC.
8.3 Secondary Sales
In such cases, some or all the shares are sold to other investors in secondary transactions before the full exit takes place.
The time from initial investment to exit can be anywhere between 5-10 years. Successful exits provide the returns necessary for a VC firm to repay its own investors and continue investing in new startups.
Conclusion
It comprises many stages and a multitude of stakeholders in the venture capital process, from deal sourcing to final exit. Each of these is very critical to turning promising startups into successful companies.
That is an important concept for an entrepreneur to understand as they seek to raise venture capital money. This helps prepare for setting realistic expectations and steering through the complexity of deal negotiations.
For investors and startup enthusiasts, the venture capital process provides insight into how innovation can be bankrolled and how new technologies and business models find their way onto the markets.
While venture capital is not the answer for every startup, at least for those with high growth potential and big appetites for capital, it can provide the fuel needed to turn big ideas into world-changing companies. As the business continues to undergo changes, no doubt the process of venture capital will evolve along with; however, its core mission—funding innovation—is likely to be a central part of the startup ecosystem for many years to come.
