What Is Venture Capital & How Does It Work?
Venture capital: As an entrepreneur, you’ve undoubtedly heard of it, but you may not be familiar with exactly how it works or whether it could be a good option for your business. You may be wondering if your startup is even eligible for venture capital. Keep reading to learn what venture capital is, what sorts of businesses and entrepreneurs are good candidates for VC funding, and how to go about tapping into this resource!
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What Is Venture Capital?
Venture capital is a type of equity financing where investors provide capital to a young business with high growth potential in exchange for equity in the business. In addition to ponying up startup funds, VC investors also give direction to the companies they invest in to help them succeed. The venture capitalist’s long-term goal is to make a profit when the company they invest in goes public or is sold to another company.
Venture capital firms are usually looking to invest in tech companies, though some may specialize in healthcare or other industries. Most VC firms specialize in a specific type of industry, focusing on businesses that are in a particular stage of growth. VC firms are often located in or near tech metropolises, such as New York City, San Francisco, Boston, and Austin, and usually (but not always) focus on businesses in their immediate region.
How Venture Capital Works
Most everyone has seen Shark Tank, but in actuality, there’s a bit more to VC than making a quick pitch to a room of hyper-critical rich people. Securing VC funding is a little less intimidating than defending your life’s work to Mark Cuban in under five minutes, but it’s also a long, multistage process. It requires a significant amount of patience, diligence, and flexibility, as you may have to change your company to fit your investor’s vision for growth. You should also keep in mind that VC funding is extremely competitive, and your company must have a lot to offer potential investors — only about 0.05% of startups are able to obtain this coveted form of capital.
Venture capital is not a loan; venture capitalists invest in companies in exchange for equity or ownership in the company, betting that they will make money if your company does well. So what are these entities that supply venture capital? Generally, they are investment firms (rather than individual investors). Venture capital investment firms raise and pool funds from a range of sources, from corporations to nonprofits, pension funds, and wealthy individuals. These investors are limited partners in the venture capital firm.
VC financing is risky for the investor, which often loses money when a company fails. However, they know that not every company they invest in is going to be the next Uber or PayPal. The VC investor can offset their risk by investing in many different businesses, some of which may deliver a phenomenal profit. Most VC firms make a profit of about 20% a year.
How Venture Capital Compares
Venture capital shares similarities to certain other types of startup financing, but there are also some important differences you should know about.
Venture Capital VS Debt Financing
As mentioned, venture capital is a form of equity financing. Equity financing differs from debt financing in several ways. Namely, debt financing is structured as a loan, which you have to pay back with interest. However, the debtor is just a debtor; they don’t own any part of your company or have any say in your business decisions. Some examples of debt financing include lines of credit, business credit cards, and SBA loans.
Venture capital is not a loan, so the recipient does not have to pay it back or pay any interest or fees. VC also includes more than just capital — you also get business guidance and mentorship. But in exchange for the help getting your business off the ground, you have to forfeit some control over your company to the venture capital firm. Also, unlike debt financing, which serves a wide variety of business types, only certain kinds of businesses — technology and innovation businesses with high growth potential — are good candidates for venture capital.
Read Pros & Cons Of Debt VS Equity Financing to learn more about the differences between debt financing and equity financing (such as venture capital).
Venture Capital VS Private Equity
Venture capital and private equity are both types of equity financing and are similar in several respects. PE investment firms and VC investment firms both provide capital to privately-owned companies, using pooled funds from investors that are limited partners of the firm. The main difference is that VCs invest in startup companies in exchange for a minority stake in the company (less than 50%). In contrast, PEs invest in mature companies for a majority stake (more than 50%).
Also, while VC-backed companies tend to be innovative and tech-focused, PEs tend to invest in traditional industries, such as retail, restaurants, and manufacturing. The types of mature companies PEs invest in need capital to expand, address inefficiencies, or fix stagnation related to lack of capital.
Venture Capital VS Angel Investors
Angel investors also have a lot of things in common with venture capitalists. Angel investors invest in privately-held companies in exchange for equity, but these investors tend to be high net-worth individuals or groups of individuals (rather than investment firms). Most angel investors are entirely profit-motivated, but some angel investors are at least partially motivated by philanthropy. For example, there are angle investment groups dedicated to helping fund underserved business owner demographics, such as women-owned businesses or veteran-owned businesses.
Angel investors typically offer smaller investments and have a more hands-off approach to supporting your company. They also tend to serve a wider variety of industries than VC companies and offer more flexible terms.
When Venture Capital Is The Right Choice For Your Business
The following are attributes of business owners who are well-suited for venture capital investment:
- Your business is related to technology or innovation (some examples include web-based tech, sustainable energy, fintech, healthcare technologies, scientific research, software development, electronics, and telecommunications)
- You are fine with eventually selling your company, and you have an exit plan if you do sell
- You can see your company going public at some point, and you have considered the pros and cons of doing so
- You are okay with divesting some control over and stake in your company to an investor (control freaks and VCs aren’t a good mix)
- You are a serial entrepreneur (or aspire to be one); that is, you develop companies with a plan to sell them or take them public and then start another one
- You have a lot of business connections, and, ideally, some of these connections are in VC
- Your company is located in or near a venture capital hotspot (such as the Bay Area, Silicon Valley, LA, NYC, etc.)
If Venture Capital Is The Right Fit: Next Steps
Do you fit the above criteria? Here’s what the process of obtaining venture capital might look like for you.
The beginning of your venture capital journey is all about finding the perfect fit. It’s a lot different than getting a bank loan, where you simply apply to various lending institutions that provide financing for a variety of business types. With venture capital, you need to find an investor that caters to your specific type of business in your particular stage of growth — for example, semi-established fintech companies or healthcare technology companies that haven’t gone to market yet. Location matters, too — whether your company is based in the Bay Area, Silicon Valley, or elsewhere, you will want to find and nurture VC contacts in your local market.
Once you have found a suitable VC firm to approach — and, ideally, you should already have a relationship with this firm rather than contacting them out of the blue — you can pitch your idea/company and see if they will consider funding you. If it’s a good fit, and they decide to move forward and invest in you, the investor will perform a valuation of your company, both before and after the cash infusion. The valuation will determine the percentage of stock the VCs will own in the company and may also determine the amount of influence the investors have in steering the company before your IPO or sale.
Stages Of Funding
After a deal has been agreed on, funding begins. This usually happens in several rounds, the first of which is called seed funding. Seed capital is meant to get a very new business off the ground (the average seed round is $2.2 million) and may be used to do things, such as develop a prototype, assemble a management team, or create a business plan. Successive rounds of funding, called series, may become available as the business expands. Series A funding and Series B funding, for example, focus on somewhat-established businesses that are already offering a product and have a customer base, whereas Series C funding helps mature companies expand or even acquire other companies. Different venture capital firms usually cater to different specific phases.
From sending your pitch deck to attending meetings with investors to performing due diligence, it can take from six to nine months or longer to get your first round of seed funding.
Learn About Other Types Of Financing For Startups & Entrepreneurs
If VC isn’t the right fit, that’s okay. There are many other types of financing that might be better suited for your small business. Some options include small business loans, small business grants, crowdfunded loans, personal loans, and lines of credit. Start your research by checking out these resources with relevant information about various forms of startup financing.
- 8 Alternative Funding Sources If Venture Capital Isn’t The Right Fit For Your Startup Or Small Business
- 6 Financing Options For Up & Coming Entrepreneurs (Plus 4 Expert Funding Tips To Get You Started)
- 20 Best Ways To Finance A Business Start-Up
- What Is Venture Debt & Is It The Right Type Of Financing For My Startup Business?
- What Is Debt Crowdfunding & When Is It The Right Choice For My Small Business?
- Small Business Startup Loans: Your 8 Best Options
- Do I Qualify For A Startup Grant?