Venture Capital (VC): Understanding its Mechanism, Benefits, and Differences from Bank Financing

1. What is Venture Capital (VC)?

Venture Capital (VC) refers to specialized companies or funds that invest in emerging, unlisted companies (venture companies) with the potential for high future growth.

Many emerging companies often need more funding in the early stages of establishing their businesses. Venture Capital steps in by providing the necessary funds for these companies to grow and introduce new ideas or services to the market.

In return, Venture Capital acquires a portion of the company's stock. Subsequently, when the invested company goes public or is acquired by another company, Venture Capital sells the held stocks, realizing the meaning of capital gains from the stock sales.

To enhance the value of the invested companies, Venture Capital engages in activities such as providing funding, management advice, and dispatching executives.

2. Venture Capital Risk and Return

Venture Capital (VC) engages in investments to achieve high returns that justify the substantial risks involved. Given that VC investments typically entail higher risks and returns compared to general stock investments, investors need to possess sufficient knowledge and experience to navigate this landscape.

2.1. Risks of Venture Capital

In many cases, VC investments are directed toward early-stage emerging companies that are not yet mature. These companies often lack sufficient revenue or have yet to establish a solid business model, leading to a heightened risk of failure.

Investing in new markets or technologies comes with uncertainty regarding market acceptance. Additionally, the world of emerging companies is highly competitive, carrying the risk of being outpaced by other firms.

2.2. Returns of Venture Capital

When the invested companies succeed, their valuations can experience rapid growth. Consequently, VC stands to gain significant capital profits. Moreover, early-stage investments allow for relatively inexpensive entry, and successful outcomes yield substantial returns.

The realization of VC investments can occur when the invested company goes public or is acquired by a larger corporation, enabling the conversion of the investment into cash.

3. Mechanism of Venture Capital

The operations of Venture Capital (VC) primarily encompass the following three aspects:

3.1. Capital Mobilization:

Venture Capital engages in investing its funds into unlisted emerging companies. Additionally, it may establish investment funds (investment business associations), soliciting contributions from institutional investors, individual investors, financial institutions, and corporate entities. In some cases, VC acts as the fund manager.

3.2. Investment in and Recovery from Unlisted Emerging Companies:

Utilizing the gathered capital, VC identifies promising emerging companies and makes investments by acquiring their stocks. Subsequently, when the invested company goes public, the VC sells the held stocks, or in the event of the company being acquired by another entity, the VC liquidates the stocks. The proceeds from such sales are distributed to the investors as capital gains, with a portion serving as success fees for the Venture Capital.

3.3. Management Support for Invested Companies:

Naturally, if the invested companies do not experience growth, anticipated returns may not materialize. To ensure the success of investments, Venture Capital provides more than just funding; it offers management resources. This includes strategic advice, guidance, and, in some cases, introducing optimal personnel or dispatching executives to the invested companies.

4. Loan investment difference: Differences Between Venture Capital and Bank Financing

The most significant difference between the two lies in the presence of repayment obligations.

Bank loans, being a form of "liability," entail repayment obligations, including interest.

On the other hand, investments from Venture Capital fall under "equity," and no repayment obligations arise. However, as the primary goal of Venture Capital is to gain profits, especially during the listing of the invested company, generating returns is expected once the investment is received.

Moreover, bank loans involve assessments, making it difficult for early-stage, less-established startups to secure financing. In contrast, Venture Capital is assessed based on growth potential, providing an opportunity for early-stage companies to receive investment.

5. Differences Between Venture Capital and Investment Banks/Investment Funds

The distinction between Venture Capital and investment banks/investment funds lies in the growth stage of the target companies.

Venture Capital primarily targets emerging companies, such as startups, with anticipated future growth.

On the other hand, investment banks and investment funds focus on matured companies.

Forecasting future growth rates for emerging companies is challenging compared to matured ones. Venture Capital, therefore, invests in companies at challenging stages for investment decisions compared to investment banks and investment funds.

6. Types of Capital Venture: A Comprehensive Overview

Venture Capital comes in various forms, each characterized by its origin and unique features. Here, we introduce representative types:

6.1. Financial Institution-affiliated Venture Capital:

These are Venture Capital firms established by financial institutions such as banks and securities companies. With robust financial resources from their parent institutions, they can handle substantial investment amounts comfortably. Examples include Mitsubishi UFJ Capital (affiliated with Mitsubishi UFJ Bank), SMBC Venture Capital (affiliated with Sumitomo Mitsui Bank), and Mizuho Capital (affiliated with Mizuho Bank).

6.2. Independent Venture Capital:

Independent Venture Capital operates without being tied to a specific parent company. Examples include Jafco and Japan Asia Investment. Being independent allows them to make investments without constraints.

6.3. University-affiliated Venture Capital:

University-affiliated Venture Capital involves direct investments from universities, utilizing research results and human resources, including alumni. Tokyo University's Co-creation Platform Development Co., Ltd. (Tokyo University ICP) is an example. Other designated national universities, such as Kyoto University and Tohoku University, have been allowed to make direct investments since April 2022.

6.4. Government-affiliated Venture Capital:

Government-affiliated Venture Capital operates under the administration of national or local governments, utilizing public funds for investment. Examples include DBJ Capital affiliated with the Development Bank of Japan and the Regional Economic Revitalization Support Organization (REVIC), established for regional economic regeneration.

6.5. Corporate Venture Capital (CVC):

Corporate Venture Capital involves companies operating Venture Capital. Examples include NTT Docomo Ventures (affiliated with NTT Docomo) and STRIVE (affiliated with GREE), a well-known player in the gaming industry. Companies run CVC to bring in external perspectives and knowledge for their growth.

6.6. Region-specific Venture Capital:

Region-specific Venture Capital focuses on investing in companies located in specific prefectures or municipalities. Examples include Hokkaido Venture Capital from Hokkaido and Niigata Venture Capital, which aims to create a "New Silicon Valley" in Niigata.

6.7. Overseas-affiliated Venture Capital:

Overseas-affiliated Venture Capital refers to Venture Capital with foreign capital (foreign-owned companies) as the parent entity. Examples include Sequoia Capital with investment records in Google and Yahoo!, and Kleiner Perkins Caufield & Byers (KPCB) with investments in Amazon and Compaq.

There are also hybrid forms, such as "Overseas Financial Institution-affiliated Venture Capital," combining characteristics of overseas and financial institution-affiliated Venture Capital.

7. Advantages of using venture capital

The following are the benefits of raising funds from venture capital:

7.1. Easier to raise funds

As introduced at the beginning, compared to banks and other financial institutions, venture capital firms make investments in anticipation of future growth and profitability, so it has the advantage of making it easier for start-up companies to raise funds.

By raising funds from venture capital, you will have a track record of raising funds, which will increase your chances of receiving financing from financial institutions such as banks.

7.2. No repayment obligation

If you receive a loan from a bank, etc., you will be required to repay the principal and interest on the due date.

On the other hand, funds raised from venture capital generally have no obligation to be repaid. There is no need to repay the invested capital because the company transfers its shares in exchange for the investment.

For start-up companies, the ability to obtain funds that do not need to be repaid is a big advantage, as various expenses are incurred in the early stages of business. This reduces the financial burden on your company and allows you to focus on running your business.

7.3. You can utilize the management resources and know-how of venture capital.

Venture capital companies often have a rich investment track record, and one advantage is that you can utilize their management resources and know-how. To improve the corporate value of an investee, it is common to provide management advice and guidance to the investee.

8. Considerations When Raising Funds from Venture Capital

When raising funds from Venture Capital, it is essential to be mindful of the following points:

8.1. Potential for Management Interference:

When securing funds from Venture Capital, there is a possibility of management interference. In exchange for the investment from Venture Capital, it is common to transfer company shares. Depending on the percentage of voting shares transferred, there may be a risk of excessive intervention in the company's management or a requirement to make decisions aligned with the policies of the Venture Capital firm.

8.2. Dilution of Ownership Percentage:

Obtaining investment from Venture Capital involves transferring existing company shares, leading to a reduction in ownership percentage. The decrease in ownership percentage can result in insufficient voting shares for resolutions at shareholder meetings, reducing the company's influence and decision-making power.

According to Article 309-2 of the Companies Act, a special resolution at a shareholder meeting requires the presence of a majority of voting shareholders and approval from two-thirds or more. Additionally, under Article 309-1, an ordinary resolution requires the presence of a majority of voting shareholders and approval from a majority.

Given these requirements, the ownership percentage, especially the majority or two-thirds, becomes a crucial criterion. Therefore, careful attention is needed to monitor changes in ownership percentage when receiving investment from Venture Capital.

8.3. Pressure to Demonstrate Results Early:

Venture Capital, managing funds from other investors, places a strong emphasis on whether the investment is yielding positive results.

If successful, there is an expectation to quickly monetize and distribute returns to investors. Conversely, if the investment is not performing well, Venture Capital may prefer an early exit. Consequently, companies receiving investment from Venture Capital are expected to deliver results swiftly.

9. Process of Receiving Investment from Venture Capital

Here is an overview of the main steps involved in receiving investment from Venture Capital:

9.1. Submission of Necessary Documents:

To facilitate investment decision-making, Venture Capital firms typically request the submission of specific documents. While the required documentation may vary between Venture Capital firms, a business plan is usually mandatory. Commonly requested documents include:

9.2. Evaluation Determines Investment Approval:

After the submission of documents, Venture Capital conducts an assessment of the prospective investment target. This evaluation considers not only the submitted documents but also industry trends, and results of independent due diligence by certified accountants and lawyers, among other factors. The decision to invest or not is based on this comprehensive evaluation.

9.3. Approval from Investors at Review Meeting:

Once Venture Capital decides to invest, an investment review meeting is convened involving the investors. During this meeting, the Venture Capital must explain the post-investment nurturing and support strategies. Obtaining approval from the investors, who constitute the final decision-making body within the Venture Capital, leads to the formalization of the investment contract between the Venture Capital and the target company.

Following the review, adjustments are made to investment conditions such as the valuation of the target company, the set amount for stock prices, the percentage of shares to be held, the amount of investment, and the timing of the investment.

10. How to Encounter Venture Capital

Here are some options for making contact with venture capital:

10.1. Introduction Through Acquaintances or Business Partners:

Typically, directly reaching out to well-known venture capital firms may be challenging, and there's a possibility of not getting much attention. To mitigate this risk, getting introductions to venture capital through acquaintances or business partners increases the likelihood of making contact. However, it's essential to note that whether you can secure investment depends on a rigorous assessment of business growth potential, making effective presentations and negotiation skills crucial.

10.2. Meeting Through Events and Business Contests:

Participating in events or contests organized by venture capital firms provides another avenue for encounters. Many venture capital firms host events dedicated to entrepreneurship and startup support. Utilizing such opportunities is an important way to find venture capital. Both sides, entrepreneurs, and venture capital, often attend these events with the mutual goal of finding favorable investment opportunities, which can facilitate smooth communication if needs align.

10.3. Utilizing Support Programs from Chambers of Commerce and SME Support Organizations:

Chambers of commerce and SME support organizations engage in activities to introduce venture capital to small and medium-sized enterprises (SMEs) seeking investment. In addition to traditional financing options like loans from financial institutions, these organizations provide information about venture capital based on the specific needs of companies seeking investment. This support aims to foster the healthy development of SMEs by addressing their financial and investment requirements.

11. Conclusion

Venture capital is an organization that invests in startup companies or newly established ventures with the expectation of future growth. The primary objective is to acquire shares and later sell them at a high price during events like initial public offerings (IPOs) or corporate acquisitions.

When raising funds from venture capital, there are advantages such as ease of fundraising and no repayment obligations. On the flip side, there are potential drawbacks, including the risk of excessive intervention in management and a decrease in ownership percentage.

Therefore, it is crucial to assess the feasibility of raising funds from venture capital based on these characteristics. Given the limited opportunities for traditional companies to connect with venture capital, seeking expert support is essential when considering and deciding on utilizing venture capital.

For startup companies, aside from fundraising through venture capital, there is also the option of obtaining strategic resources through M&A.