Whatever stage of the business cycle a company is at, financing will always be a key consideration!
Companies need sufficient funds to ensure continuity of operations. Funds might also be required to enable a route to market, invest in technology, build expertise and resources or conduct product research. However, early-stage companies may not always have the funds available internally. In this case, they may have to explore external financing options.
While there are various types of financing available to companies, in this article we focus specifically on Venture Capital – a type of private equity that focuses on investing in early stage startups and SMEs.
What is Private Equity?
Private equity is a source of financing for private companies – companies that are not listed on a public stock exchange. It is an alternative to other sources of liquidity, for example, a bank loan which is a form of debt financing that generates ongoing interest payment liabilities.
Private equity will generally come in the form of funds invested in a company by financial institutions, focused investment funds and/or individuals. In exchange for the financial investment, the investors will generally receive equity shares in the company which entitles the investor to ownership of the company, involvement in overall management, board decisions and a degree of control.
We previously wrote about the key information that investors want to know about the accounts and finances of a company!
Venture Capital is one type of investment activity that falls under the category of private equity investing.
What is Venture Capital?
Venture Capital is a type of financial investment from a third-party investor (individual or organisation) into a target company. It is differentiated from other forms of investing in that venture capital financing will generally be more focused on companies that are at the earlier stages of their business cycles such as startups – pre-operations or early operations, or early-stage and emerging SMEs.
Investors will consider these types of companies as attractive investment opportunities where the company shows real potential for growth and a potential for generating a healthy financial return for the investor in the near future.
How does Venture Capital financing work?
A company may require investment/funding for a specific and clearly identified reason. For example, funding may be required to help a company expand into new markets, invest in technology development, move to new offices premises or build out operations to align with sales growth. Companies may also seek financing to help manage cashflow during a period of financial uncertainty (e.g. COVID-19).
When a venture capital investment is completed, the target company will receive an injection of capital or cash into the business. In contrast to a bank loan, there would generally not be any interest related to this type of equity investment. There may, however, be a requirement to pay dividends (distribution of profits by a company to its shareholders).
In return for the financial investment, the venture capital investor will receive a number of shares and a % ownership of the company.
As a result, the investor will have ownership rights, management rights and usually, board rights, in the company. The extent of these rights will depend on the agreed terms of the investment deal. The terms of the agreement will largely depend on the agreed value of the business, the level of funds being invested, the % of shares being sold and the bargaining power of the respective parties.
Venture Capital for Different Stages of the Business Cycle
As mentioned above, venture capital is a type of equity investment that is more focused on early stage startups and SMEs that have high growth potential.
The below are just some practical examples of the scenarios in which companies at early stages of the business cycle might consider venture capital financing.
The Company: Generally at this stage, an individual will have an idea or project that they believe can be successfully brought to market. The owners and founders may invest some of their own capital. However, depending on the size and requirements of the project, they may need additional financing from outside/third party investors to get the project off the ground. The business would not be making money at this stage.
If you are in the process of starting a company, check out our article on the key accounting concepts that every business owner should know!
The Investor: The investor will assess if the idea, product or project actually has market potential. The investor will want to understand if the business idea can actually be turned into a viable market product or service and if there is a real business opportunity. At this stage, it is common for the third party investor to be an individual or an entrepreneur. These type of individual private equity investors are commonly known as ‘angel investors’.
The Company: The company may already have a viable product or service. The company is now looking for funds to help launch to the wider market and start focusing on commercialisation and growing the company. An investment may assist with increasing inventory, new equipment, larger facilities and more specialised. The company might also require a new investor to open up a wider network of contacts. The company is still unlikely to be generating significant profits (if any at all).
The Investor: A venture capital investor at this point will focus on the company’s business plan as well as ensuring that the right people are in place to achieve the commercial objectives. The investor will also want to understand the proposed timelines for generating a financial return.
The Company: In the case, the company may have already started generating sales/revenue and is now looking to sustain these level of sales, increase sales margins or start scaling. In this phase, the Cash Flow Statement and Profit and Loss account may still be in the negative. However, as the business is starting to generate revenue, it is an indicator that there is a market for the product or service.
The Investor: An investor will be comforted by the company’s transition to market and ability to generate revenue. The investor will, however, want to understand the company’s plans for achieving real growth, the ability to sustain such growth as well as the pipeline for the next level of growth.
Check out are article which identifies 5 expert finance tips for preparing your tech startup for growth in the Philippines!
Key Considerations for Startups and SMEs when exploring Venture Capital financing
There are a number of key factors that startups and SMEs must consider when exploring venture capital financing for their business:
Source of Finance
Is venture capital the right move for the company at this stage? Does it make more sense to obtain a bank loan (i.e. debt) to fund activity for the near future? Should the company work with an angel investor or a private-equity fund? Are the founders ready to lose part of their ownership? The source of financing that a company choses is crucial for the future direction of the business.
Founders and owners have to decide how much of their company they are willing to sell. This can be difficult for the people that have worked hard to build their own business from the ground up. However, bringing in a venture capital investor may be the only way to fully realize the business opportunity. Owners and founders will generally have to be ready to lose a certain degree of ownership, management responsibilities, directorship duties and in general, full control of their business.
A company should explore what experience and knowledge a venture capital investor has in their sector or with the product the company is selling. In addition to the finance, a company can benefit greatly from the expertise, industry knowledge and experience that can be gained through the venture capital investment, particularly if the new investor will be taking a hands-on approach within the company. A real strategic venture capital partner can provide significant benefits for a company.
A key benefit that a new investor can bring to a company is their network of other companies, clients, partners and industry representatives. The right investor can really benefit and increase the stakeholders involved in the ecosystem of an early-stage business.
Venture capitalists go through a long process of screening and assessment of a company before deciding to invest. This is called “due diligence”. The investor examines all aspects of the company – including finances, legals, operations, labor compliance, products, tax compliance, etc. Once an investor decides to invest in the target company, this can affirm the reliability, robustness and potential of the company to grow and succeed. The higher the profile of an investor in a particular sector, the greater the level of validation for the company.
When exploring an investment through venture capital financing, both the investor and the company founders/owners need to consider their long-term objectives for the company. Generally, venture capitalists will want to invest in the company and exit at the earliest opportunity after having generated a positive return on their investment. Venture capitalists will generally invest for timeframes of 5-7 years (depending on the business/industry). The owners/founders will need to consider what they wish to do with the business in the short to medium term. This is a key item for exploration when discussing the terms of an investment with a prospective venture capital investor.
CloudCfo – Online Accounting and Bookkeeping Services for Startups and SMEs in the Philippines
When considering financing for your startup or SME, venture capital is just one option. However, it is a specific option that focuses on early stage businesses.
CloudCfo offers outsourced online accounting and bookkeeping services for startups and SMEs in Manila and across the Philippines. We have supported many companies with their strategic growth objectives as well as preparing for receiving an investment. In particular, we ensure that clients have their books of accounts and finances in order to ensure the due diligence process runs smoothly on the finance side.