Venture Capital

Venture capital firms invest in five different stages of a company’s growth. The amounts invested are often industry specific and vary from company to company. A seed or startup round for a capital-intensive business—like semiconductors may require millions, whereas a software company may only need startup funding of $100,000. These stages are general guidelines, and may sometimes overlap.

Seed

This is the initial stage: when an investment of between $1,000 and $500,000 is made in a company’s embryonic stage. The process involves a handful of people with an idea and little or no revenue and/or a start-up investment of between $50,000 and one million in private companies that are completing product development and beginning initial marketing. For example, a divorced mother has an idea to start a social networking Web site for others in the same situation. The site isn’t even running yet, but she has a business plan for www.singleparents.com and is looking for someone to give her the money needed to get started. She’ll look for seed money from venture capitalists willing to take a chance at a very preliminary stage.

Early Stage

An investment of between one and $15 million is made when a company has completed its product but has unimpressive revenues. At this point, the start-up may have trial customers accounting for a sizable portion of its revenue. Following the previous example, the entrepreneur has the social networking Web site up and running in beta. The new company already has had initial investment, and operates like a small business with designs to expand on a national or global scale. The added venture capital dollars has allowed singleparents.com to hire a small staff—sales positions, Web designers, copywriters, and others—and open a base of operations. Early stage is also called First Stage, First Institutional Round, First Letter Round, and Series A.

Later Stage

An investment of between $2 million and $15 million is made when a firm has a successful product and revenue, and has often already taken money from other institutional investors. After benefiting from early-stage investment, singleparents.com has a growing amount of subscribers and is luring an increasing amount of online advertisers. This next tranche of cash allows them to push even farther by opening bigger headquarters, hire more staff needed for a major expansion, beef up advertising, and buy the needed servers and computer equipment to handle a rush of new subscribers. At this point the company has become so successful that the press is buzzing about it and singleparents.com has the attention of Wall Street’s army of investment bankers. Later stage is also known as Second Stage and Series B.

Mezzanine

An investment of between $2 million and $20 million is made into a company for a major expansion, generally leading to an initial public offering in 3 to 18 months. singleparents.com now has a chief executive, a president, and a chief financial officer. The company has shown a steady record of revenue, and kept expenses down to show a strong profit. This is a Web site that is at the top of its game, routinely mentioned as the “next big thing,” and has even become part of the American lexicon like “Google it” or “Facebook me.” This is about the time that those venture capital funds that passed on seed, early stage, and late stage financings begin to kick themselves. An IPO is certainly in the offing. Mezzanine is also known as Third Stage and Growth Stage.

Bridge

Often, the term “bridge financing” is used to describe a speedy financing of a company that is in trouble and needs some more time to get to a more substantial round of financing.

But sometimes a bridge financing is a bridge to an initial public offering (IPO). In this case, “bridge” refers to an investment between $2 million and $20 million made 3 to 12 months before the company goes public. (“Going public” means it issues equity shares available for purchase by the public.) Another common way to say “going public” is “IPO.” The company is typically profitable at this stage. Back in the heyday of the Internet craze, dot-com companies were able to generate enough support to list their shares without even being public. Shareholders were eager to buy into the next big thing, and that emboldened them to overlook any balance sheet problems. Those days, however, are gone.

There are several reasons a company might take on a round of bridge financing just prior to its public flotation (when it would presumably raise a lot of money). It may want to bolster its books in order to be more attractive to investors. The company alternatively might want to snare a prestigious board member/investor or in order to increase its stock value. Finally, some companies may want to hedge their bets in case of a failed IPO.

Banks and other institutions often supply bridge financing for upstart companies, sometimes in exchange for taking a bigger role later on when that company goes public. However, the credit freeze in late 2007 and ongoing financial challenges in more recent years have made many investment banks more selective about where their capital is used. Bridge financings have not dried up completely, but fledgling companies can’t get them with the same ease they once could.

The “Capital” in Venture Capital

Where do buy-side funds get their money? Most of the money comes from pension funds. Capital is also derived from endowments of nonprofit institutions (such as colleges, universities, museums, and foundations), insurance companies, banks, wealthy families and individuals, and corporations. Pension funds are money set aside by corporations (typically large) for their employees’ retirement. These assets pile up over the years and can amount to billions of dollars. The money must be invested so that its value will be sufficient to cover the needs of the employees at the time of retirement. To maximize return and minimize risk, the pension money is invested in many places—stocks, bonds, currencies, real estate, and “alternative investments.”

Typically, 5 to 7 percent of the total funds are invested into what pension fund managers call “alternative investments,” and what we call the “buy-side” firms. Pension fund managers expect higher rates of return (10 to 30 percent) from these alternative asset investments, and they understand that there is a commensurately higher risk associated with such investments. The aim of the buy-side firms, including venture capital firms, is to provide high rates of return to their investors. Only by producing high rates of return can buy-side firms continue to raise money and thereby stay in business.

There is also increasing interest in providing capital to upstart companies from private equity funds. Since 2006, PE shops have cashed-in on the merger and acquisition boom. Firms like Blackstone and KKR—which have reaped massive profits in recent years—are putting their money to work by seeking out venture capital opportunities. But, like pension funds, their quest is still to make a strong return. Private equity firms are savvy and patient investors. Even if the economy begins to slip, most PE firms are comfortable with sinking money into young companies—mostly because it is just a fraction of their massive cash stockpile. Again, venture capital investments are for the patient and often take four years to develop into the next IPO sensation.

Venture capital firms are therefore beholden to the pension funds, endowments, and private equity firms. (Following the “golden rule” logic, the venture capital firms tend to have the upper hand with companies into which they invest.) These power relations don’t always hold true. When a venture capital firm produces very high rates of return on a consistent basis, pension funds will compete to invest in it, allowing the venture firm to dictate terms. Venture capital firms may also compete to invest in a particularly hot start-up (perhaps one with a high rate of growth, or one started by a serial entrepreneur with a track record of success).