Startup 101 – What is Venture Capital Funding and an IPO?

what is venture capital funding and IPO

Now that we have already covered what is bootstrapping and what is seed funding and angel investing, let’s move on to the next thing that a startup generally looks at to give a boost to its financials. It is a sad fact that most of the startup founders today think having a huge funding round from a Venture Capital as a goal rather than just a step in the process to build the company. This is in part because of the success many e-commerce companies in the country have achieved by raising capital. The underlying truth still remains that none of them is able to generate any profit still. So what is a Venture Capital and what is an IPO? Find the answers below:

Venture Capital

Venture Capital is the funding that a startup founder most looks forward to. It runs into millions of dollars and is utilized to scale up an already functioning product which could have a few or many paying customers. Venture capital could be controlled by a small group of people or an individual and invests money in multiple startups. Venture Capital funding is generally raised before the company decides to go for an IPO. The changing landscape of the startup ecosystem means that today Venture Capitals are betting big even when the IPO is not even in sight. This type of funding which does provide a huge amount of cash for the startup does take away a huge stake away from the founders of the startup and liquidates the stake of the early stage investors (angel investors) as well. Interestingly, not so long ago, Venture Capital was known as ‘risk capital’ because of the fact that it was a risky investment. Given that no investor likes to use capital and risk in the same statement, it is called venture capital ever since. Given that VCs take a lot of things into account before investing into a startup unlike early stage investors, the risk associated is considerably less. The things have changed but now VCs again are looking for profit first startups rather than going for startups that are still looking to expand their customer base. Venture Capitals can be said to be one of the major players that contributed to the dot-com bubble of the late 1990s. The correction in the market in the millennium year led to a radical change in the way VCs invest in startups. In terms of India, a bubble similar to that of the late 1990s was seen in the last two years and is still persisting.

Also Read – What is seed funding and angel investing

Given that the India is riding the wave of positive sentiment from around the globe, VCs are betting big. For the past few years the e-commerce segment is where the VCs were betting high in India but as of this moment are moving away from the segment into newer territories like FinTech and EduTech startups. Most of the startups that succeed today owe their success in part to the capital they raised from a VC. The reason for this is not just the money that they offer but also the advice that helps you clearly understand where your company could and should go. Also, given that all members of any Venture Capital are reputed people from different industries, being associated to them paves the way in terms of getting more customers on board especially for B2B business.

If you are a startup that has a good customer base and has a clear vision of where you want to take your company with a clear roadmap, Venture Capital investment should be the next logical step. If a VC is convinced and is ready to pour in the funds, it validates that your startup can grow and do so rapidly. In the early years, VCs looked to get a good return on their investment annually to the tune of 30-50% per year but today, they like to take up a stake in the startup. It is important for the founder of the startup to be aware of the stake that the VC is demanding. It has been seen several times in the past wherein the Venture Capital takes the majority stake in the startup thus gaining the authority to make decisions for the company. Seldom, the founders of the company are ousted by these Venture Capitals to steer the company in the direction they desire. That is one reason why new age startup founder term them as Vulture Capitals.

The few reasons why Venture Capitals invest in a startup include:

-Room for rapid growth
If the VC feels that the company is a domain that could see rapid growth giving them good return on investment.

-An effective and efficient team
When a startup goes for a VC funding, it is ideal that there are more than just the founders in the team. That not only portrays that you are generating money but also shows that there are enough people working on different aspects and none is being overlooked. Of course, it is also important that you have the right people in your team. The management team i.e. the founders should be dynamic and should have an all-in attitude towards the company. That is what excites VCs the most.

-IPO
If a VC senses that your company can either be acquired by a larger company or if you are in a new domain altogether, go for an IPO, it provides them with an exit strategy that they all desire for.

What is an IPO

IPO is an Initial Public Offering. Most VCs and startup founders call IPO as ‘going public’. This is the final step in terms of the funding goals for a company. It can easily be termed as the endgame for both founders as well as all the investors involved. For an entrepreneur, it is nothing short of a dream to have a publicly listed company. For those who aren’t aware of the term at all, IPO or Initial Public Offering is when the company offers stocks or shares to the general public to raise capital. Once the IPO is subscribed, it gets listed on the stock exchange and the shares are traded. It also allows the existing shareholders i.e. VCs, seed funders, angel investors, founders and employees with stock options, the choice to sell the shares. The shareholders can trade the money on the stock market and the profit or loss made on the shares is incurred by the shareholder. Also, the company also shares the profits that it makes in the future with its shareholders in the form of a dividend. Also, if a company is looking to offer an IPO, there are two options it can choose from:

-Fixed Price Method
In this method, the price at the securities are offered is fixed before the IPO is floated.

-Book Building Method
In this method, the investors have to bid for the shares within a price band. The price band and the bidding process is generally handled by an investment bank. This price band is decided by the board of directors of the company looking to float the IPO. They do so in consultation of the investment bank handling the entire process. Interestingly, it is upto the board to decide the price band but in certain industries, the security board regulations of the country need to be adhered to. Once the band is decided, the bids are invited and the bid can be for any amount between the band range. Depending on the bids that are received, the seller then decides what is the optimal value to be set for each share and then the shares are sold at that price.

ALSO READ: What is Bootstrapping and lean startup methodology

Even though IPO has been the ultimate aim of all the entrepreneurs for so long, the new age entrepreneur has started thinking differently. The are a number of reason why so many successful startups shy away from launching an IPO including:

-Time Commitment
An IPO requires a huge time commitment that has the downside of distracting the founders from the product. For a startup, nothing is more important than the product and lack of vision or lack of time given to the product could lead to disastrous results

-Investor sentiments
It is a known fact that whenever a negative news or a meltdown happens, it is the publicly floated companies that face the brunt. Hence, today’s entrepreneur feels it is better to raise another round of VC money rather than going public.

-Skepticism towards tech stocks
Given that most of the startups today belong to the tech domain and ever since the meltdown of 2000, not a lot of investors are prone to investing in tech stocks. This was proved by Infibeam’s IPO which saw a rocky start and was oversubscribed by 1.1 times. Sure it was oversubscribed but had the company belonged to a different domain, there is a high probability of it being oversubscribed many times over than just 1.1 times. It will be interesting to see how Flipkart, Snapdeal and PayTM are received by investors if they ever end up floating an IPO.

-Constant Pressure to Increase Earnings
While this is something that any investor be it the public or a venture capital looks for from a company. While for a Venture Capital, if the increase in earnings isn’t constant or takes time, the things can be explained but for a publicly floated company, the stock prices plummet or rise depending on the earning reports. That is a risk that entrepreneurs want to avoid.

-Increased Exposure
Given that startups run in a way that is very different from a traditional company, the need to disclose things like the decision-making criteria, compensation formulas and operational financial details puts the entrepreneurs off.

-Risk of takeover
It has been seen in the past that a publicly floated company is part of hostile takeover or a friendly one at that. Either way, the founders lose control of the company and that is something they never want to happen. Of course, huge VC funding also has the capability of taking away the control but then things are in the control of the entrepreneur if he is willing to part from the desired stake or look for funding somewhere else.

-Communication Hassles
When a company goes public, there are a number of hassles involved which include the need to keep all the shareholders up to speed of what is happening at the company. Also, being in constant touch with analysts, steering the company in the direction the investors wants and keeping up with things like legal reporting. Given that most founders today are young, dynamic but not necessarily have the ability to handle all of these things simultaneously leads to them being ousted from the company for tarnishing the image of the company.

Hence, going for an IPO should be reserved as the last option possible that too when you are a huge company generating huge revenue and are already a household name. While IPO option as an exit is something that all venture capitals look for, for you as the founder, it is advisable to let the company mature before you take the decision of going down that road.

ALSO READ: 10 TED talks every entrepreneur should watch

1 COMMENT

  1. Excellent article. One thing I liked that people are doing now is owning stock that give control but not money returns. That way people can’t take you over. Thanks for writing!

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