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A Path to Understanding the Essential Workings of Venture Capital

By: Damilola Aderinto

Between 2010 and 2019, we experienced a record-breaking milestone of $730 billion invested by Venture Capital into the Startup Ecosystem. In 2019, Africa’s venture capital investments were at an all-time high, according to Partech’s report. 234 African technology companies raised $2.02 billion, indicating a 74% increase from 2018’s $1.163 billion raised by 146 startups in 164 rounds. These figures look amazing, but they are nothing compared to the African Venture Capital Space’s future statistics.

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If you are reading this, then the chances are that you have noticed the rapid growth of various startups (in the tech space), with terms like fundraising, venture capital, equity, SAFEs, term sheets, financing, private equity and many more terminologies used. Well, not to worry, the idea behind this article is to provide a simplified understanding of the essential workings of Venture Capital.

My Experience getting into Venture Capital?

It is incredible to see techpreneurs discussing what they do and how the business model works, but one common thing is the existence of an idea and a need. Ideas remain in your imagination until they are actualised. Until the idea ventures off the paper or your mind into reality, it is considered wishful thinking. It can only become a reality when it becomes operational. For businesses to run operations, they require funding (capital). This is where Venture Capital comes in.

In 2019, when my co-founders and I came together to solve one of the pressing issues in the technology space at the time, we realised there was a lot we had to learn about the space since all we had was the experience of building businesses and being angel investors. Although I had managed a fund while I headed operations in Street Capital between 2017 and 2019, there was still a lot of experience to be uncovered. The venture capital space is continually changing, but our ability to disrupt the ecosystem by opening the space to other methods of raising capital for businesses was a key factor.

According to Wikipedia, Venture capital is a form of private equity financing provided by venture capital firms or funds to startups, early-stage, and emerging companies with high growth potential or have demonstrated high growth. Venture capital is that financial investment injected into a company at its early or development stages. The acquisition is to aid the business in running operations or expansion purposes. Though simple, there exists cases in the venture capital world where several injections are made in the formation stages of the company. We will discuss the different stages later in this article.

Before proceeding to the different stages of businesses that Venture firms invest in, let’s quickly go through how venture capital works. I will be explaining this part based on my knowledge and experience with the applications in the portfolio companies I manage at Future Africa. There are four major players in the Venture Capital Space, namely:

  1. Entrepreneurs who need funding for their businesses;
  2. Investors who want returns (also called the LP because they invest in the Fund)
  3. Strategic corporate investors and
  4. Venture capitalists (usually called the General Partners, and they manage the investment Fund)

In many cases, Venture Capital firms mitigate startup investment risks by  co-investing with other venture capital firms. The way it works is through the presence of a “lead” investor (A venture capital firm leading the investment round) and then several “followers.” The followers are also venture capital firms who invest in the same deal as the lead investor.. Venture capital firms prefer to have two or three investment firms involved in most stages of financing. Relationships or situations like this create portfolio diversification and increases the ability to invest in more deals per dollar of invested capital. The presence of several VC firms adds credibility to the deal. In Future Africa, we have a collective of investors (institutions and individuals) with whom we co-raise investment capital. Over time, this approach has helped us mitigate the risks involved in assessing deal flows and staking on the investment.

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Types of Venture Capital Funding

There is a type of venture capital funding for every stage in a company’s lifecycle. The different stages of the business define the kind of funding they receive from the venture capital firm or investors.

  • Pre-Seed Funding: This is the earliest stage of funding for any company, and it usually is at the time when the founders are just getting the business up and running. At this stage, many founders self finance the business or source funds from family and friends and rarely raise capital investment from venture capital firms. This mostly plays out because the founders are still testing the product’s viability in the market or trying to acquire the customers required to grow the business. Depending on the type of business and cost of operations involved, the funding process can happen either quickly (if the founder has the funds to support the company) or could take some time (in situations where the founder needs to explore external sources of finance). This does not imply that a venture capital firm cannot invest at this stage, it only explains the ideal workings.
  • Seed Funding: This is the first official equity funding stage. This is the first capital that a business raises for expansion or growth. We can use the analogy of planting a tree to describe the seed stage funding in a company. If this seed is sewn into the business with a successful business strategy and the investors’ perseverance and founders’ industriousness, the company will eventually grow into a tree. This early financial support is what is needed to grow the business. Seed funding helps a company finance its first steps, including market research, hiring talent and product development. These guide the company in determining what the final product will look like. Angel investors tend to invest in riskier ventures, most times startups with little or no proven track record, and expect a higher equity stake in the company in exchange for their investment. In 2019, the median seed round investment was $500,000, with a $3-$6 million valuation.
  • Series Funding: When a business has proven it has a good track record (an established customer base, good revenue figures and any other key performance indicator to show growth or potential for growth), the company can start considering or working towards the series funding. Sometimes, companies at the seed stage have excellent ideas that can generate substantial customer bases, but there can be a lack of clarity in the monetisation of the business. The seed funding can help the company with marketing costs, product development costs, expansion costs, talent acquisition and other expenses required to grow the business. This class of funding can range from Series A to any letter. Still, many companies stop at D before getting to a level where external financing is unnecessary to push the business forward. This type of funding is used to make companies ready to be listed on the stock exchange, which measures the business’s success.
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Company profiles differ with each business type and model; risk profiles and growth levels are quite different in each funding stage. Nonetheless, seed investors and Series investors help founders realise their dreams. Series funding enables investors to support entrepreneurs with the proper capital necessary to carry out their plans, perhaps cashing out together in an IPO.

My experience has been built on businesses in the early-stage funding phase. In Future Africa, we believe this stage is the most challenging for companies without established trust in the market or with more prominent investors. This stage also allows us to be more profitable if the business does well since the valuation in this stage usually is lower.

Company Stages in Investment

Just the same way everything in life has to go through stages, companies or startups also metamorphose. As mentioned above, the different stages of the business determine the kind of investment required to push it to the next level as a measure of growth.

  • Startup Stage: this is when the business is established and is in its very early stages of operations. The founding team often strategises and documents how the product might work in the market. Once they get it right here, other parts of building the business evolve effortlessly, especially in focused teams. I have worked closely with companies to understand that this is a crucial phase for them.
  • Seed Stage: At this stage, the business might not be running full-scale operations but is developing the product or service. This stage mainly enables product development, market research, management team building, and business plan development. This is when the company receives investment from external sources like venture capital firms in exchange for equity. Venture Capital funding in this stage ranges between $250,000 and $1,000,000.
  • Early Stage: Here, companies have begun their operations but may not be at the stage of commercialisation and sales. This stage of business may have its first customer or obtain a minimal amount of early adopters and might have been in business for around three years. Venture Capital financing at this stage primarily supports expanding operations and customer acquisition and may even help further IP protection. Funding at this stage usually ranges between $500,000 and $5,000,000.
  • Growth Stage: This is one of the broadest defined stages of Venture Capital financing due to the amount of capital and the reason behind the funding. The growth stage means the company is starting to become an established player and there is evidenced growth in its numbers or operations. The funding is mostly for marketing, product development or improvement, and product or market expansion locally or internationally. Growth stage funding ranges between $1,000,000 and $25,000,000.
  • Mezzanine Stage: is the financing stage that bridges the gap between company/market expansion and the business filing for an initial public offering or IPO. This financing stage is often done via debt financing and can range from $5,000,000 to $100,000,000.
  • Private Equity: This financing class invests in companies with very high valuations, facilitates leveraged buyouts or LBO, and assists in management takeovers. Investors here are usually institutional investors due to the capital involved. They tend to invest in asset classes which include equity securities and debt in companies that are not publicly traded on a stock exchange. The funding in this class ranges between $25,000,000 and $100,000,000.
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Features of Venture Capital

Irrespective of the type of funding or the stage of the business the venture capitalist is interested in investing in, specific characteristics are similar across board. As an experienced VC operator, these features have been coined while dealing in the space. While experiences vary within business types, these features are constant and cut across the board.

  • High risk: Venture capital investments are a very risky type of business. The future is unknown, and there is little or no data proving the firm’s past successes. It is considered the most dangerous type of investment. The earlier the stage of the business, the higher the risk. We typically stake against nothing but an idea here.
  • Equity: The investment is usually in the form of equity, where the investor owns and holds a part of the company until it is time for liquidation.
  • Lack of liquidity: VCs cannot sell their securities and get the cash because they feel like it. The investments are locked until an event leading to the desired liquidity, like an Initial Public Offering (IPO) or the sale of the company, comes up. Another alternative is selling their part of the company to a willing buyer (this process is called Secondaries).
  • Long term: Venture capital investments are long term. It takes a long while for VCs to get a return on investment (ROI), if at all they do. It can take between 5-and ten years for the companies to produce returns. This is one of the unique qualities of the venture capital space, and you require grit and patience.
  • Active participation: Unlike the banks and its loans funding type, VCs don’t just give out the funds and wait for returns; they can stay involved in the business management and sometimes micromanage the company’s activities to ensure growth in the business. Entrepreneurs sometimes consider this a disadvantage of venture capital investment, although it can sometimes be advantageous, especially when it leads to business growth.

Venture capital has become very popular recently; venture capital and VCs are becoming more popular thanks to the emergence and exponential growth of tech companies and other niches. There are several sources of venture capital in the ecosystem, and some of them include:

  • Institutional investors (investment banks, financial institutions)
  • High net worth individuals or Angel investors
  • Venture Capital Firms

Venture Capital plays a nurturing role by staking in an entrepreneur’s vision and actualising it by injecting the required capital needed to realise the dream. Still, it is essential to note that this investment is precarious.

From my experience, 90% of start-ups do not get to the IPO stage, 30-40% fail, another 30-40% will return just the invested amount, and only about 10-20% will deliver on expected returns. These numbers tell a vivid story of the risks we face as operators and businesses in the Venture capital industry, but that does not mean one cannot try. I have met people who want to be tagged as Angel investors but are not willing to undertake the risks involved in the business of investing. You cannot eat your cake and have it, but one can mitigate the risks with the right skills and experience.

*Damilola Aderinto is a Tech enthusiast with a keen interest in funding innovations and building early stage start-up companies for growth

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