Venture capital: What you need to know

The term “venture capital” refers to the form of capital investment that takes place outside the stock exchange and falls under the collective term “private equity”. Venture capital providers are mostly banks and credit institutions, large companies or even insurance companies; private investors are less frequent. In the following section, we have summarised the most important questions for you regarding venture capital:

What is venture capital? 

Specifically, venture capital is an investment form that is very risky and is particularly used for financing investments in start-ups. In German, venture capital is referred to as ‘risk capital’ or ‘Wagniskapital’. Venture capital providers invest part of their equity capital in mostly young, innovative companies and expect a correspondingly high profit; sometimes with a very high risk. For their investment, they receive company shares that they can sell after a certain term or that are converted into shares at a later possible IPO of the company, which can thus increase in value. Venture capital as such is not traded on the stock exchange; it is therefore a form of private equity.

Investing in venture capital is relatively simple: The investor invests his assets in an investment fund of a venture capital company, which in turn provides several selected start-ups with funds from the venture capital providers. In return, these investors receive company shares that guarantee them certain rights of participation, depending on the contractual arrangement. Star-ups do not have to repay or pay interest on the invested risk capital to the investors.

The typical lifespan of a VC investment is ten years. Accordingly, investors usually also withdraw from the operational business by selling their investment. This life span is divided into two phases: the investment period and the harvest period. The first phase is about acquiring financiers, the second phase harvests the fruits of the investment. For the management of the investment fund, a fee of usually 2% of the investment sum per year is payable to the investment company. Although VC funds can deliver high returns, they are also subject to equally high risk. For this reason, the fund capital is usually distributed by the fund company among several investments (“diversification”).

What are the forms of venture capital?

Within the framework of venture capital, a differentiation is primarily made according to the type of investment:

  • Direct investment: In this method, the investor invests directly and without “intermediaries”, i.e. not via a fund or investment company. This is often the case with classic business angels. 
  • Indirect investment: The counterpart to this is the indirect investment in which the investor invests in a fund of a venture capital company and not directly in the start-up. 
    • Fund-dependent: In this case, the investment in the company takes place indirectly via a venture capital fund, which is managed by the VC company.
    • Fund-independent: There are also VC companies where the investment goes directly into the company and not via a fund.

For which target group is venture capital interesting?

In particular, young entrepreneurs or start-ups are interested in this form of equity financing, as they do not have to provide collateral, unlike within the framework of a bank loan. Established companies can of course also consider this form of financing if, for example, they have already taken out a bank loan and have an additional financing requirement for the development of new products or to enter into new markets. But it is not only financial investment that is relevant to many start-ups: By bringing experienced investors on board, they also benefit from their knowledge and wealth of experience and can use them as an advisor. In addition, as long-standing entrepreneurs, venture capital investors are usually well networked, which also benefits young entrepreneurs.

On the investor side, venture capital is particularly exciting for entrepreneurs willing to take risks, who also want to contribute their knowledge and experience to companies that have not yet been established and help them achieve future success. Investors who not only contribute financially, but also proactively and constructively to the management of young companies are also called “business angels”.

Financing with venture capital: How does a financing round work?

As part of venture capital financing, there are a few phases for start-ups to go through:

  1. Pitch presentation: The young entrepreneurs present their company, their products and their idea to potential investors as part of a pitch. These investors should be able to gain insight into the business idea and evaluate the feasibility of its opportunities and risks.
  2. Creation of the “term sheet”: In a “term sheet”, i.e. a document that contains the essential business or summarised pre-contractually investment conditions, the most important key points of possible participation are recorded. In addition to the amount of the financing, for example, the rights and active participation in the company's operational business are also recorded, and the exit scenario is described.
  3. The due diligence provides for a precise review of the legal and financial situation of the company. The purpose is to better understand the start-up and to uncover possible risks before investment and possibly eliminate them early.
  4. Creation of the equity interest agreement: In cooperation with a legal adviser or a start-up consultant, the equity interest agreement is prepared and signed by both parties after a thorough review.

What are the stages of venture capital investment?

Venture capital financing can take place at different stages of the start-up:

  1. (Pre-)founding phase or “seed stage”: In this very early phase, the start-up company usually deals with product development and testing of market readiness. At this stage, investors are still at the highest risk as the company is not (really) active in the market.
  2. Start-up phase or “early stage”: In this second phase, the market entry usually takes place, which in many cases can be very capital intensive (advertising, announcement of the company, etc.).
  3. “Growth stage“: Phase three is about scaling and making the business model successful. Since larger investments (e.g. in better machines, increased advertising and marketing, building an online shop, additional employees, etc.) usually have to be made for this, capital is also required in this phase. The risk is usually lower at this stage of growth than during the first two stages; it is easier for young entrepreneurs to find lenders.
  4. “Later stage“: In the later stage, start-ups have transformed into profitable companies and often no longer require participation financing. In this phase, the “exit”, i.e. the departure of former investors, is more the topic. 

The investment needs of companies often differ due to the different phases. While some are satisfied with a one-off financial injection, other start-ups may need a capital increase at a later stage, which can be provided by investors in tranches.

What are the advantages and disadvantages of venture capital?

From the start-up's point of view, the advantages clearly outweigh the disadvantages resulting from venture capital financing:

  • Liquidity and planning security: Through financial security from external investors, the company receives cash that will help develop the company and drive innovation in medium-term planning without having to worry about credit repayments.
  • Know-how of investors: The accumulated wealth of knowledge of the investors means that young entrepreneurs in particular benefit and can therefore learn from experienced advisors who in turn have an interest in the company's success and thus pursue the same goals.
  • Using networks: Investors also usually make contacts from their broad networks available to young entrepreneurs, which can lead to partnerships and cooperation.

The following could be seen as disadvantageous by the investees:

  • Right of participation: With the financial support, entrepreneurs also buy into the decision-making bodies of the start-ups, which can lead to a certain loss of control from their perspective.
  • Changes in structures and processes: through the investment, investors become co-owners and thus also decision-makers, which can lead to changes in already established structures and lead to longer decision-making processes.

For investors, high potential returns on investment (ROI) are offset by high risk of loss, as returns can only be generated by increasing the value of the company. Total losses are not excluded in a young entrepreneur environment and are quite common. 

Conclusion

Venture capital represents an interesting form of investment financing of start-ups within the framework of private equity: Although the risk is very high from an investor perspective, many VC providers promise high returns and also support young entrepreneurs with their knowledge, experience and network. VC investees should be aware of the possible loss of control or a certain interference by investors and should plan potential exit scenarios of the financiers in advance.

Legal advice on venture capital

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Please note: The above explanations are not exhaustive. They are only for initial information. They do not replace in-depth advice. We would be happy to help you with this.