Investment in Venture Capital

Venture capital operations are a form of financing that involves the contribution of capital to early-stage or early-development companies with high growth potential and elevated levels of risk, in exchange for a percentage of the company shares.

This article provides a basic guide to understanding how venture capital investments work, their purpose, and how they can be carried out. It also explains the different types and characteristics of venture capital investments.

What is the objective of this type of investment? 

Investing in venture capital (VC) aims to increase the value of the company as quickly as possible. This approach seeks to achieve the highest possible profits on the investment at the end of the agreed period. 

This is done by injecting capital into the company to facilitate rapid growth and market consolidation, thereby increasing the value of its equity. 

In which VC projects can one invest?

Depending on the stage of the project or company receiving the capital, four types of investments can be distinguished: 

(i) Seed capital: Prototypes of companies that have not started economic activities or even formulated a business plan yet.

(ii) Spin-out: Companies derived from academic institutions, universities, etc., aiming to leverage the resources of the original organization for new business opportunities.

(iii) Start-up: Newly established companies with viable projects.

(iv) Early/Late stage: Recently established companies with viability but at a more advanced stage than start-ups.

How to invest in VC? Equity investment vs.convertible loan 

The decision to bring in investors is made by the VC company, and it can choose between two alternatives: receiving direct equity investment or providing convertible loans. 

For the investor, both instruments offer the opportunity to generate profits, but they represent different ways of financing: 

• Into an equity investment, the investor injects capital and contributes know-how and at certain times professional expertise to the target company in exchange for receiving shares.
• In contrast, convertible loans allow short-term financing of a company to receive compensation in the form of converting their credits into the company`s shares.

Equity investment is often more attractive to investors as it allows them to receive compensation in the form of shares of the company without waiting for a future and uncertain moment. 

On the other hand, convertible loans are less complex for the target company, allowing them to delay the introduction of new partners into the company, and letting the entrepreneurs to keep control of their company at the initial phase. However, the disadvantage in these cases is the existence of a debt that must be paid to the investor within a specified period of time. 

What types of company valuation exist? 

When identifying a target company for VC investment, different types of discounts or valuations can be considered: 

• Discounted cash flows: this valuation considers future cash flows, determining the present value of a business based on anticipated earnings in the future. It is one of the most common methods used for this purpose but has the disadvantage that the value of money is temporal, so the final valuation can easily change.
• Asset-based: in this case, only the valuation of business assets is considered, not the liabilities. It is especially suitable for companies with investments in stock markets or real estate.
• Market-based: it is done by making comparisons between similar companies in the sector. However, this calculation may not be completely accurate as it depends on similarities between the product, balance, revenue, and growth rate.
• Liquidation value: this method relates the assets and liabilities of the company to determine its value in the hypothetical case that the company is going to be dissolved and liquidated at that precise moment. The calculation is based on a reduction of assets with the company`s debts. 
• EBITDA: As is known, EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is the most used method, as it does not consider external factors or non-operating expenses, focusing on the operational performance of the business.

Types of investors

When a person decides to invest in VC, they can choose between different business models: business angels, venture capital funds, risk capital funds, and financing through family or trusted individuals. 

• Business angels act independently to invest their own capital in companies with the aim of being part of the project. In this case, the investor does not act through a business vehicle. 
• Venture capital funds have the advantage of exclusively dedicating themselves to financing startups. They have experts responsible for seeking innovative projects with high growth potential. They provide capital collected from external investors to make injections into different target companies. 
• Funds dedicated to investing in venture capital funds are entities that invest in investment funds with their own portfolio, thus adding a very broad and diversified list of target companies. 
• Finally, many entrepreneurs decide to use their personal network to raise capital for their business projects. In this case, investors, who are family and friends, invest based on their relationship with the target company`s administrators or partners, and it is not common for them to provide strategic knowledge for know-how improvement. 

If you want to learn more about this type of investment, Gentile Law can help you understand it and provide guidance.