Morning boys and girls. It's been a hard week for all of us but now let's talk about something nice, new HNFC article for example. Today we want to talk about alternative investment option, the Venture Capital (VC). Shall we start? Ready Set Go!
Venture Capital… What a name. In just two words, you can define the atmosphere of the notorious Silicon Valley, home of Shazam, Snapchat… This term is often used in the news. It has not always been the case because the Venture Capital sector, and all its glory, is all relatively new in the world of financial instruments and products.
Despite being used globally for its trendy innovative image, the term “Venture Capital” names a complex sub sector of the financial industry. Not complex because of its operating but because of its opacity and secrecy. However, because of the growing importance of this sector, you should get more interested (and now informed) it than ever before.
Today, Sam (Me) breaks down for you this sector. How does it work? What does it seek? And who are involved?
Venture Capital, what is it?
Venture Capital (or VC) is a part of the financial system dedicated to investing money at an early stage in young firms with a high potential of growth (like a football club when they recruit a ‘wonderkid’).
What we call Venture Capital are all the funds and private investors that look at this type of start-ups. To name but a few, Benchmark Capital, Accel Partners, and Oak Investment Partners as big role player in the industry.
The aim for the investor is to be an early shareholder of the company during the incubation period, to eventually make a huge profit when the company will become well known and public (Ideal scenario, if not just highly profitable). The particularity of VC is how focused it is on innovative sectors (and how risky it is).
To present it in a funny way let’s take an example:
John is a very good cook. He has red a ton of books about to prepare a delicious cheesecake and found a marvellous but innovative way of cooking one. He is sure that his cake will be so delicious that all the neighbourhood will want a slice. The problem is: the ingredients cost £100 pounds (very big cheesecake indeed) and he has just £50 pounds.
John meet Samuel and presents him the “Cake project”. John explains how good and innovative it will be, how good he is at cooking and say that the cake will be valued at £3000 pounds if everything goes well. John offers £50 pounds of capital. Samuel is a risk taker and gives him the £50 pounds for the cake. Samuel now owns 50% of the cake.
John cooks a wonderful cake that even your grandmother would be proud. The neighbourhood is fond of this cheesecake, and it is bought for a total amount of £3000 pounds. Samuel made a profit of £1450 pounds.
In this case: the cake is the start-up, John the entrepreneur, Samuel the VC investor and the cake purchase is the IPO (the entrance of the start-up on the stock market).
What a story right? But imagine that John did not succeed at cooking. He burnt the cake or what he thought was good is disgusting to everyone else, then what? Samuel would lose the amount that he invested. In our case it is “just” 50 pounds. Just think about the first guy who invested in Twitter. It was a first investment of 5 millions of dollars.
Thus, Venture Capital is a risky sector because investors cannot rely on lots of information to their opinion as they focus on disruptive and innovative projects (Cheesecake business maybe?). Samuel, in our example must trust John and only John. He has no clue about the cake’s quality because it does not exist yet. (As the first investor in Twitter did not know how great the social media sector would be.)
Venture Capital, how does it work?
The investments are not made through a dedicated stock market. Start-ups offer their capital privately. They go through a fund raising period with the emission of a shares’ series. This process can be repeated several time. For example Twitter used 9 fundraising periods before making its entrance in the real stock market world (IPO).
Each funding period is called a “Funding Round” and each funding round has its own emitted share’s Series. What does it mean? Let’s go back to our previous example.
Let’s imagine another case where the cake costs £300 pounds to be perfectly cooked. John has already offered £50 pounds of its cake capital through the emission of a Series of shares called “Seeds” (the very first funding round) to Samuel.
He has now £100 pounds. He still needs £200 pounds to succeed at his cake’s cooking. John knows that nobody will invest in his cake right now. So he starts with the 100 he has. He prepares a nice dough and show it to his parents. The dough seems really good, so his parents give him £100 pounds to make the cake.
He must find the £100 pounds left to get all the ingredients. With his capital of £200 pounds, he can prepare another part of the cake and show it to his grandparents. The cake is going to be good! His grandparents give him the last £100 pounds. John finishes the cake and the neighbourhood buy it for £3000 pounds.
With this example, we can clearly see that John goes through three funding rounds. The first is the Series “Seeds” bought by Samuel, the second is the Series “A” for instance bought by John’s parents and eventually the Series “B” is bought by John’s gran parents.
With no consideration for familial relationships, we can assess that:
So at the IPO (the cake’s purchase by the neighbourhood). Each investors (Samuel, John’s parents etc.) will receive the percentage owned on the 3000 pounds.
We just broke down funding rounds.
But, I’m sure something disappointed you during John’s cake funding. How can John’s parents earn more than Samuel while they entered when the investment didn’t carry as high a risk? (They had the cake’s dough for proof)
That’s why every Series of shares has its own characteristics and price. The first Series (often called “Seeds”) are the riskiest in a classic approach. Because the first investor gives the first start to the business. Hence, the “Seeds” shares have low price and additional options which give attractiveness to the Series (e.g. a promise of limited losses, a seniority position….). It is like when your mother put some chocolate on this weird apricot pie. You are less reluctant to eat it.
Thus, when you look at start-up capital generated via Venture Capital investors, you must know that each round has their own particularities. If you want to develop this aspect of the VC industry you can take a look at our article on VC-backed companies’ valuation.
Venture Capital, why is it successful?
There are two reasons for the VC industry success: the utility of the sector and the exponential growth of users.
When a young start-up wants to expand, there aren’t a lot of alternatives: banks, market or crowdfunding.
In the first case they would ask for a loan. This is not a great option as a loan is difficult to obtain when you are a young start-up, and if you obtain one you should pay high interests and should pay-back your loan quickly. It is surely not a suitable option. Although, just to give a balanced opinion, a loan does off a funding strategy without the need to typically sacrifice any equity of the business.
The stock market is impossible to reach. You cannot offer yourself going public while you are just a little project and working in your parent’s basement.
Websites such as Kickstarter or other fundraising websites are good options, but it is seldom to raise periodically huge amounts of money on those places. Investors are often retail investors with little capacity. If you wish to succeed with a funding round of 2 million, you need a solid business plan, a great sales pitch and targeting the right investors.
Venture Capital finds its space in the gap between the two previous options. Venture Capital is a convenient way to raise a lot of money (because investors are big time players) without exposing the project to unwanted costs (interest) or short-term barriers (loan length). Therefore, the VC industry becomes so useful to so many fledgling business’.
However, the VC industry’s success is directly linked with the revolutionary era that was the noughties. Thousands of projects were born during the internet bubble and the technological revolution. Those pioneering projects did not find suitable investment through traditional financial products. It is thanks to those start-ups and projects that the VC sector has enjoyed such phenomenal return, thus solidifying an excellent reputation and a more mainstream avenue business’ can explore whilst in their incubation or start-up phase. Shazam, Twitter, Snapchat, Facebook, AirBnB, Uber. They are all big companies that changed our world in some way or form. Revolutionaries that roots can be found having bloomed from within the Venture Capital method of funding. Venture Capitalists haven’t done too bad out of it either.
Now you can go to “Crunchbase” and inform yourself about VC backed companies.
I hope this article helped you. See you in the next story my friends :)
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Written by Samuel Chaineau│Co-founder of HNFC
Edited by Graham Laxton & Vee Venski
This article is not a promotion of financial investment. Investing money in financial instruments is risk-reward process. Losses and gains are part of financial investment process. Only invest money you can afford to lose.