With the media frenzy that Facebook has caused on the way to a possible $100 billion IPO, I thought it might be appropriate to discuss the venture capital process and how it affects both the company and the market.
As a credit professional, I’ve dealt with established Fortune 1000 companies as well as quite of few start-ups. Along the way I’ve had to come up with a few ways to establish acceptable thresholds of risk depending upon where the companies were in their growth stages and what sort of risk was hanging in the balance.
Venture capital is provided to early-stage companies, with high potential (and high-risk) for growth. They make their money by having equity in the firms in which they invest. So, to put it mildly, they have “skin in the game.”
All venture capital is private equity, but not all-private equity is venture capital.
If the enterprise is a small venture, then perhaps they can rely on such capital sources as family funding, loans from friends, personal bank loans or crowd funding.
Some ventures have access to rare funding resources called Angel investors. These are private investors who are using their own capital to finance a ventures’ need but they take a passive role regarding company management.
For more ambitious projects, something a bit more substantial is in order. For these situations often times a pooled investment (often an LLC) will provide funding that is too risky for standard capital markets or bank loans.
THE STAGES OF A START-UP FUNDING
Seed stage funding - Typically used to pay for market research and development. Seed capital is generally provided by those with a connection to the new enterprise although it could come from the founders themselves. It is not unusual for seed funding to come from family, friends or angel investors. These investment dollars tend to be lower (in quantity) and the risk very high.
First stage (start-up stage) – A business plan gets presented to the venture capital firms, a management team gets formed to run the venture, if a board of directors exists, a member of the venture capital firm will take a seat on the board of directors. After reading the business plan and the proper consultation, the investor decides whether or not the idea is worth further development.
Second stage – At this stage the idea has now been transformed into a tangible product and is likely being produced and sold. The venture is striving to reach the break-even point. The management team must prove its’ mettle to the venture capitalists. The VC firm will monitor how management navigates the development process and deals with competitors.
Third stage – The capital that is provided to a company with an established commercial production and a basic marketing set-up, looking for market / plant expansion, acquisitions, and product development. At this stage the company should be enjoying revenue growth but may not yet realize a profit.
Mezzanine stage – This is late-stage venture capital, usually describing a company which is somewhere between startup and IPO. To be even more exact Mezzanine Financing is for a company expecting to go public usually within 6 to 12 months. The expectation is that the proceeds from a public offering will repay this financing or at least establish an opening price for the IPO.
The further along the process a company goes, less risky the VC-firm’s investment becomes.