VENTURE CAPITAL IN LAYMAN'S
TERMS
Imagine this:
You just came back from office, very tired. You enter
your home and just want to crash on the couch. But you can't. You have to
switch on the light, fan and/or AC, turn on the TV, switch on Wi-fi etc. So one
day when you were feeling very tired, this brilliant idea struck you. How about
a device, that could do all this for you, automatically, as soon as you enter
your house? (This type of device already exists, but lets just say it doesn't).
So you set down to do your research. Every evening you
spend one hour thinking about how this device could work, what problems could
it face, how it will handle those etc.
Soon you have a workable plan. Now you need more time to
work out the finer details and complete your product design. So you leave your
job and start living off your savings.
In two months, you have a perfect design. Now you want to
start making prototypes. So you take the help of your friend from college who
works in an electronics manufacturing company. You pay them some money from
your savings to produce the prototype.
After testing 5 versions of the prototype, you find the
product is ready to go into production. But you also find that you have
exhausted all your savings. You don't have money to hire employees or buy
machines or anything. What do you do now? Do you abandon all this work and go
back to your job? What if someone comes up with a product like this in the
meantime?
So you go to your uncle who has lots of money. You ask
him to invest in your idea. He says that he will invest the money, but will
need 12% interest on the funds. You can't accept this term because you know you
won't start making money right away. Hence you can't pay him interest.
Then he asks, if he doesn't get interest, why he should
invest. So you say, you will incorporate a company and give him 30% stake in
the company. This way, if the company starts making profits, he will get 30% of
the profit share.
He agrees to this term and gives you the money against
30% shares.
Now think about it. You are not making any profits. Your
product has not been tested by the market. You don't know how many units you
will be able to sell. You don't even know if you will be able to sell at all.
So why did your uncle give you the money?
This is what a venture capitalist does. They take a bet
on companies which show potential and possibility to generate a lot of profits
in the future. This is a high risk area as the company may very well fail to
perform.
Most companies that venture capitalists fund are young
and loss making. It is valued based on its sales volume, past growth rate,
future growth potential etc. Since such companies cannot get loans, they
generally sell stake in the company to raise capital.
This is what venture capital is.
Bibliography:
- Quora
- Courtesy CA Gourav Kumar
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