What is “Venture Capital?”
As opposed to stocks, bonds and cash, which are known as traditional investments, venture capital falls within the domain of alternative investments. Venture Capital is usually private equity or alternative funds that are structured as limited partnerships and seek to purchase, optimize and finally sell portfolio companies, in order to make profits. When a venture capital fund divests its portfolio companies, it is known as the exit ” or the final investment stage. Such divestment typically occurs either through an initial public offering (IPO), merger with another company, or acquisition by another company.
Key Learning Points
- Venture Capital is termed an alternative investment, and is typically private equity investment in newer or smaller companies
- The three key stages of venture capital funding are the “start-up” stage, “seed” stage and the IPO or sale of the company stage
- This is deemed a more risky type of investment than traditional avenues due to the early-stage nature of the companies typically invested in
- In the valuation of venture capital deals, there are two key concepts – post-money valuation and pre-money valuation
Venture Capital Funding
To make an investment, a venture capital fund needs to be convinced that the business or the portfolio company’s management team is competent and that it has a solid business plan, along with strong prospects for growth and development.
As such investments are typically in young or early-stage companies that are not yet mature businesses with years of operational activity and a history of financial performance. The complexity involved in venture capital is accurately estimating a company’s valuation based upon the future prospects that may be many years down the line.
Such estimates are based on a series of wider variables which can make them difficult to accurately quantify. Traditional equity market investing or LBO investing is usually based on a sizable track record and a longer financial history in developed and mature companies which can make it easier to forecast the growth based on past performance.
The stages of venture capital can range from the inception of the company idea, all the way to the stage where the company undertakes an IPO, or more typically sells to a strategic buyer. The required return by investors will vary based on the company’s stage of development. Investors in the very early stage demand higher expected returns relative to later stage investors, as the perceived risk is higher.
The earliest stage of investing (the ”‘start up” or idea stage) is deemed to have the largest risk as there is yet to be proof of concept, no sales and no profit. Here is where friends and family investing or angel investing comes in. Funds at this stage may be used to transform the idea into a business plan and to fully assess the market potential. At this stage, funding is generally provided by individuals and not venture capital funds.
The next stage is the “seed stage”. Here seed capital generally supports product development, or marketing efforts – including market research. Generally, this is the earliest stage at which venture capital funds will invest. There may be several rounds of seed investment as a company generates initial sales and then seeks further expansion as it moves towards generating a profit.
The last stage is the IPO or the sale of the company. This is usually where venture capital investors exit the investment. There are many sub-stages between these three stages. This is just a general overview of the process.
Valuation in Venture Capital Deals
Assume that Company A is a start-up and wants to sell it. The start-up team expects that it will be able to sell the company for US$40 million after five years. Currently, they need to raise US$4 million through venture capital financing from a venture capital fund (VCF). Further, assume the set-up team owns 1 million shares in the company.
Next, there is a process of valuation of Company A i.e. the value of the company has to be determined once the VCF makes the initial investment, which is termed as post-money valuation, and a pre-money valuation has also to be made.
For this, certain assumptions have to be made regarding the terminal value of the company (i.e. $40 million is what is expected by the set-up team), time of exit, the amount of money that company A wants to raise currently from the VCF, which is $4 million.
Given the substantial risks involved of investing $4 million in company A, the VCF wants to apply a hefty discount rate of 40%.
To obtain the post-money valuation (i.e. this is the value that is being put on the entire company), we calculate the Net Present Value (NPV) of the terminal value in five years. Thereafter, the pre-money valuation is calculated.
Next, given the amount of $4 million that the VCF is investing in company A, it wants to own a percentage of shares (67.2%) of this company, in order to obtain its required ROI. The number of shares that the VCF requires to obtain, in order to attain the aforesaid percentage of shares in Company A is calculated below. Lastly, the price of shares is calculated below.