VENTURE CAPITAL IN LAYMAN'S TERMS
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.
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.
- Courtesy CA Gourav Kumar