Word in the New$: Venture capital

Feb 18, 2017 04.00PM |
 

by Ryan Ong

WHY do venture capitalists (VCs) need such big offices? It’s a common question, but if you know any, the answer is obvious. It takes about 1,500 square feet, minimum, to house the ego of one VC.

But VCs have some right to that kind of arrogance. They’re the ones who drive innovation, at huge risks to themselves. They’re the cowboys of the financial world, who take extreme risks to advance society. And now, we’re likely to see more people participating in venture capital, with the Monetary Authority of Singapore (MAS) simplifying the rules:

 

What is venture capital?

Venture capital is a high risk, high return form of investing. It’s defined by its focus on new or emerging businesses, which often don’t have a proven track record.

In traditional investing, the investors will look at a company’s 10 or 20-year history, as well as the nature of the industry it’s in. So if you’re investing in a textiles firm, you’d look at its operating margin, its sales over the past two decades, read up on developments in the textile industry, and so forth. Your decision to invest would be based on that information.

But what if you’re faced with a company that’s brand spanking new? Imagine a company that has a new biomedical device, which it claims can cure stage three cancer without surgery. If the technology really works, its investors will probably make enough money to buy China. But there’s no 10 or 20-year history to look at and no one even knows if the device will actually work. That’s where venture capital comes in.

VCs, either in the form of affluent individuals (angel investors) or venture capital firms, will take such risks in the hopes of getting high returns. This means VCs are among the few investors who often expect many of their investments to fail. Most are counting on the fact that, out of 10 failures, maybe one will become the next Google or Facebook.

From a societal perspective, VCs tend to garner more prestige than traditional investors. Apart from their “no guts, no glory” image, VCs are important in advancing society as a whole. Take the aforementioned cancer-curing device: it could save millions of lives if works. And because you and I can’t take the risk,  the VCs will do it.

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How does venture capital work?

Some VCs are private investors (many are successful entrepreneurs themselves). On the other hand, there are also VC funds that are available to accredited investors*. These funds pool money from multiple investors, and the fund manager chooses which companies to invest in.

VC funds are not a form of “long-term money”. Most of the time, VCs want to invest in a business until that business grows profitable, or is sold off at a huge gain. For example, a VC might sell off its shares in the company once it can gain a 50 per cent return on investment.

On the side of the company, VCs provide capital that it could not otherwise raise.

New businesses generally struggle to get bank loans. In Singapore, most banks will only lend to businesses with at least two to three years track record of profitability. However, most new businesses operate at a loss for some time, thus disqualifying them. On top of that, new businesses are often too small to raise money by listing on the stock market.

VCs provide an alternative for these businesses. The VC provides the funds needed and in return the business gives it equity (which is a share in the business). But this is simplistic. In reality, VCs do more than just buy equity.

Once the VCs own a percentage of the company, they are motivated to make the company succeed. VCs are often successful business people themselves – they can provide the guidance and leadership needed to grow a business. This can range from providing legal advice, to developing marketing strategies.

VCs also tend to be well connected. Getting a VC on board can help a new company get its products in a major retail chain. For example, a start-up bakery might, through a VC’s help, end up getting 200,000 orders a month from Sheng Siong or Cold Storage. A new social media company could appear on TV and be featured in a dozen magazines, if their VC has strong media connections.

In fact, companies that seek out VCs may be less interested in money and more interested in having the VC’s expertise and connections.

(*In Singapore, an accredited investor is someone with at least $2 million in net worth and an income of at least $300,000 in the past 12 months.)

 

What is the series A, B, and C funding stuff?

These terms are often used with regard to how new companies get their funding. They almost never receive all the money at once. Instead, the money comes to them in phases.

It begins with seed capital, which is when a new start-up gets money for research and development. For example, a start-up might use the money to hire a market research firm, which tells them who is most likely to buy their product and in what quantity. This may be necessary for a new product that has never been seen before. Bluetooth technology is a well cited example. When it first appeared, no one was sure who to market it to or how to sell it.

A lot of the seed money though, will go into development. A start-up that builds driverless cars, for example, might get the funds to build the first fleet of 10 vehicles.

Some VCs specialise in this area (early-stage VC firms). Providing seed capital is extremely high risk as there’s a chance the money spent will just be wasted.

Series A funding is the first major round of funding. This is where most VC funds, such as Benchmark, like to step in. At this point, the company already has a vision of what its business will be. What it needs is help to scale the operation (e.g. buying a factory to produce more, or expanding abroad). Most forms of series A funding are in the millions; think $2 million to $10 million.

Series B funding is when a business starts to grow into a major, established corporation. This kind of funding is used to expand market share, such as by hiring celebrities to promote the product, poaching world class talent from other firms and maybe putting up a building with the company name on it.

Series C funding is when other investors, such as investment banks, start to join in. The company may receive funds to acquire (or buy over) its competitors, or expand into related industries. At this point, most VCs are just trying to double or triple their returns, as they’ve found the golden goose. However, their influence will be diminished as there are other investors at this point.

 

How do MAS new rules affect any of this?

Unless you’re an accredited investor, who’s willing to park money in a VC fund, they have almost no impact on you. But MAS is lifting some requirements on VC funds, which are imposed on others. For example, VC fund managers will no longer need to appoint directors with at least five years experience in fund management.

These changes will provide a wider range of VC funds for investors who are willing to take the plunge. In a broader sense, it also helps Singapore’s innovation drive. This means new business ideas can be funded by people who have the capacity and willingness to take the risk, instead of through government support (which costs taxpayer dollars).

 

Featured image by Pixabay user Alexas_Fotos. (CC0 1.0)

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