Venture Capital Investing

One of the most powerful investment tools in the today’s financial markets is what is known as venture capital investing. The basic process of venture capital investment is as follows: Venture capitalists inject money into a particular corporation. In return for this, they receive preferred stock and the right to elect one or more directors as well as the right to receive liquidation and so on.

The structure of a typical venture capital investment is such that the convertible preferred stock of the company goes to the venture capitalist. Preference is given through this stock over the common shareholders. Even in the event of a merger or liquidation, the venture capitalist is given a preference.

The purchase of stock between the venture capitalist and the corporation is usually governed by what is known as the “stock purchase agreement”. This agreement frames the policy to be followed during the dealings with the venture capitalist and the corporation.

A venture capital stock purchase agreement tends to contain the following:

  • The price of the stock to be sold and number of shares to be purchased
  • About the condition of the business
  • Representations and warranties by the Company
  • Conditions to closing the deal
  • Various covenants by the company 

Now we shall briefly touch on the various stages of venture capital investment:

Seed or concept stage financing: As the name suggests, at this stage the venture is just an idea. This is a stage of market research, patent application, legal structuring and so on. It is likely that the money will come from the investor’s own pocket at this stage.

Startup financing: Here at least one principal will be working full time. The firm is ready to take on more managers and the prototype is ready to be launched.

First-Stage financing: The venture has now been launched.  Sales are moving upward and efforts are made through funding to reach a break-even point.The company is two to three years old.

Second stage financing: Now sales are at a peak The Company is also accumulating accounts and increasing its inventory. Emphasis is now on expansion as there are increasing demands from the marketing area asthe company begins to enter new markets.

Third stage financing: Finally the company is publicly well-known. Customers are happy and there is now a second level of managers. This is a period of expansion in various capacities depending on the nature of business.

Mezzanine or bridge financing: Finally we have a company here with a proven track record. It is ready to go public within about six months. However, there may be some loose ends to tie up like removing any debt that may have collected and buying out weak investors who are not deemed strong enough to run a public company and so on

Initial Public Offering (IPO): This is the final stage of the venture capital investment where the company finally achieves liquidity by selling its stock to the public. The founders sell of their stock and for them the entire cycle continues with another company or group.

The venture capital cycle from the point of view of the venture capitalist is actually limited to about 10 years with an extension of maybe a few more years. The actual investing cycle lasts for three to five years after which more emphasis will be on managing an existing portfolio. This will eventually result in the pulling out of the venture capitalist after selling of their stock as described earlier.

This symbiotic relationship between the venture capitalist and the companies it controls is a very relevant entity in today’s financial world as it contributes actively to the healthy economic growth of thefinancial markets in way of cash flow and creation of employment opportunities.