3.1 Venture capital and financial literature
3.1.3 Venture capital for early-stage financing
The main function of VC firms is to invest in a company’s balance sheet and
infrastructure through equity or debt until it reaches a sufficient size and credibility for
an exit (Hall & Lerner, 2010). General difficulties related to investing in startups and
early stage companies include lack of internal cash flows and collaterals, asymmetric
information and agency problems, bringing high risks, pressuring the VC to make high
returns on successful investments (ibid.). In essence, the VC firms buy a stake in an
entrepreneur’s idea, nurture it for a short period of time, and exit at a high return if the
business is successful (Gompers et al., 2015). The most common structure for a VC fund
is a limited partnership arrangement. Under the limited partnership arrangement,
individual private investors (LPs) purchase a limited interest in a VC fund, which is managed by a group of venture capitalists (VCs). Those VCs are the general partners (GPs) in the VC fund, as well as the principals, associates and investment analysts, and they charge a management fee plus a share of the capital gains to run the fund (Baker &
Filbeck, 2013).
Kaplan & Lerner (2010) highlight that despite the fact that the numbers of ventures actually receiving VC funding in the US is much less than 1%, it is considered well suited to stimulate the development of innovative fast growing businesses. Breuer & Pinkwart (2018) further emphasize the importance of VC to the wider economy, adding the importance of PE in their review of current financial literature in emerging markets.
They argue that although PE funds and VC funds are both seen as important contributors to the economy, their differences become crystal clear once one takes a closer look on the two different types of funds (Breuer & Pinkwart, 2018).
While VC has proven to be one of the most relevant sources of funding for new ventures, PE funds represent a natural financing source for firms pursuing capital-intensive and risky investment strategies, usually in maturing industries. While VC enables founders to establish young, often tech-related ventures in immature markets, PE funds typically buy firms seeking additional capital in maturing markets, e.g. through a leveraged buyout. Furthermore, Breuer & Pinkwart (2018) discuss that while VC has been seen as a supportive factor to entrepreneurship and SME growth, PE firms have been criticized for loading companies up with debt, exploiting regulatory loopholes as their investments result in highly levered firms. Others claim however that firms financed by PE funds increased their performance due to an enhanced financial scope. The fact of the matter is that PE firms tend to enter at later investment stages, and usually buy a majority stake in the ventures they invest in (Breuer & Pinkwart, 2018).
Moreover, by actively supporting the venture’s management, corporate governance, and
reporting, VC firms have been considered particularly suiting to contribute to the
professionalization of startups (Hellmann & Puri, 2002), enabling innovative products
or services to be rapidly brought to market (Black & Gilson, 1998). As Sorenson and
Stuart (2001) point out, the selection criteria and industry focus for the VC firm can vary
highly depending on the industry criteria and the environment. If the GPs have experience from a specific industry, the fund can be industry specific, in other cases it can be industry agnostic, meaning the firm will seek investments across industries.
Similarly, Mayer et al. (2005) argue that some VC firms enter at earlier stages where investment rounds are smaller and others focus on later stages where investment rounds are larger. According to the online startup tracker and information tool for many VC, Crunchbase (CB) (2020), the most common funding rounds are categorized as pre-seed, pre-seed, Series A, Series B, Series C, and Series D. Below follows an illustration of the startup financing rounds. The amount of the rounds are not fixed, nor is the order chronological, as ventures may need additional financing that does not correspond to the subsequent round provided by the model below. However this model is used to provide an overview of the investment amounts and the financing actors that correspond to these.
Figure 3: Startup investment rounds. Own construction. Source: Crunchbase (2020)
Pre-seed is the startup phase of the venture, where founders rely on informal capital to test the viability of their business idea. At this stage, the venture has no institutional investors and the capital invested is often a very low amount, often below $150k (Crunchbase, 2020). In this earliest phase, the entrepreneur is mostly relying on financial support from family and friends as well as grant funding. At the second stage, the seed funding, the venture gets capital to fund costs of product launch, early traction, bring in their first revenue, initiate important hiring and further market research for product-market fit (Riding, 2008). At this stage, Business Angels (BAs) serve the most important part of financing the ventures although some VCs enter already at this stage.
Investment sizes range between $10k–$2M at the seed stage according to CB (2020), who reports that larger seed rounds have become more common in recent years.
Traditionally, Series A is the first round of VC financing and at this stage the venture should have developed a product and a customer base with consistent revenue flow, as the investments at the Series A round focus heavily on scaling up and reaching significant recurring revenue increases. According to CB (2020) Ventures at this stage may raise up to $15 million at this funding stage. The Series B funding stage focuses heavily on the ventures ability to meet the various demands of their customers and compete in tight markets in terms of competition. Here, ventures can raise approximately $30 million during the Series B funding round (ibid.). The Series B funding stage may appear similar to the former funding stage in terms of processes and key players, however, the major difference is usually the addition of a new wave of VCs that specialize in investing in well-established startups so that they can further exceed expectations.
Generally, ventures that make it to the Series C funding look for funding to build new
products, reach new markets, and even acquire other under-performing startups of the
similar industry. As the venture’s operations have become less risky at this stage, other
institutional investors than VCs are coming into play. Apart from PE firms, which are
very active at this stage, hedge funds and investment banks invest in ventures during the
Series C stage. Ventures with good business growth, valuing up to $100 million, may be
able to raise approximately $50 million during the Series C funding stage (ibid.).
Subsequent to the Series C stage, some ventures additionally go through a Series D funding stage, which allows entrepreneurs to raise funds for a special situation, for instance a merger. A venture may consider series D funding, or bridge-financing, if it has not gone public or been acquired yet, but is contemplating a merger, and needs some runway to reach their targets. In addition to PE firms, investment banks and hedge funds, some late stage-VCs are still active investors at this stage. Startups in this stage may raise up towards $100 million (ibid.).
Business Angels Venture Capital Private Equity
Ticket Size * $10.000 - $500.000 $0.5 - $20 million, although increasing
Wide range: from $ millions to billions Investment
stage (of business) *
Founding, startup, pre-revenue;
Pre-seed stage, seed stage, A-round
Early stage, pre-profitability;
Mainly A-round, B-round and C round, sometimes also D-round and bridge financing
Mature cash flow, often deteriorating due to inefficiencies; B round, C round and D-round Type of
investment
Equity Equity, convertible debt Equity with leverage
Level of risk and return *
Extreme risk and return (100x return target)
High risk and high return (10x return target)
Moderate risk and moderate return (15%
IRR) Investment
screening
Founders, market share potential, virality, # of users
Founders, market share potential, revenue, margins, growth rate
EBITDA, cash flow, IRR, financial engineering
Ownership Small equity, own capital invested.
Below 50%, invest on behalf of LPs
Above 50%, on behalf of LPs
Purpose High involvement in management,
professionalization, go to market strategy.
Mentoring,
professionalization, growth.
Sell stake for profit through exit.
Create economic efficiency and growth.
Leveraged buyout (LBO).
Investment focus
Invest in small number of ventures
Hockey stick ventures, often within state of art technology or novel product-market fit
Traditional industries or firms with well tested business models and good traction
Table 2: Difference between BA, VC and PE: characteristics in spectrum of risk/return and stage of investment. Own construction based on: Aylward (1998); Gompers et al., (2015); Monika, & Sharma (2015); Baum & Silverman (2004); Hall & Lerner (2010); CFI (n/d); CB (2020); Hellmann & Puri (2002);
Black & Gilson (1998); Sagari & Guidotti (1992); Ramadani (2009); Teker & Teker (2016). *The figures provided should be considered as general points of reference to distinguish between the types of investor. The investor types, as explained in the paragraphs below, are constantly evolving and there is no definition that can account for all the variations.