Venture Capital
Venture capital funding is known for helping startups go from fledgling companies to multi-billion dollar industry leaders. But the venture financing process is multifaceted, and a lot happens between funding and an IPO.
Below we’ve answered common questions startups have about venture capital.
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Understanding Venture Capital:
What Is Venture Capital?
Venture capital (VC) is a form of financing in which investors provide money to developing businesses with high growth potential (startups) in exchange for equity.
VC is made up of entities (venture capital firms), individuals (venture capitalists), and investment money (venture capital funds). Venture capitalists are split into limited partners and general partners. General partners are in charge of securing funding and managing investments. Limited partners are the people and institutions (such as investment banks and retirement funds) who actually contribute the fund’s money.
Since venture capitalists focus their investments on startup companies, venture capital funding involves substantial risks. In fact, venture capitalists plan on the majority of their investments flopping—they’re fishing for the few successes that will provide major returns.
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How Venture Capital Works
If you plan on seeking venture funding for your startup, it’s important to understand the basics of how venture capital works. Below is an overview of how the venture capital process typically works—from acquiring funds to arranging exits with portfolio companies.
- Fundraising
Just like startups seek funding, so too must venture capital firms. Investment money is kept in a venture capital fund. A firm will typically have one active fund at a time, with a typical fund lifecycle hovering around 10 years. At the end of that cycle, after investments have been returned or other exits have been negotiated, a new fund may be created and a new fundraising campaign may begin. Most venture funding is provided by limited partners. General partners may provide relatively modest funds, but their main job is to secure more limited partner funding. - Match Up
Before investing, venture capitalists meet with entrepreneurs. Venture capital firms often fund companies within a specific sector, generally a sector that the investors have experience working in. For example, a firm made up of restaurateurs might focus on funding food-focused startups. So, if you’re an entrepreneur looking for investments, make sure you focus on firms that work with companies in your industry. - Investment
After being introduced to startup founders, venture capital firms will weigh the potential risks and returns associated with a particular deal. From there, they’ll decide whether to invest in a company and how much they are willing to invest. The collection of companies that VCs invest in is called a “portfolio.” - Guidance
Many venture capitalists provide guidance and mentoring to the companies they fund. Since venture capital finances startups, the business-running experience of the companies’ founding team may be limited. Venture capitalists can provide much needed advice and direction, though entrepreneurs should remember that their goals for the company may not align with venture capital goals. - Exit
Ultimately, venture capitalists try to drive their startup investments toward an initial public offering or sale (for a much higher price than their investment). Of course, not all exits are successful. Since many startups fail, many venture capital investments result in losses.
What Venture Capitalists Look For
Venture capital investment criteria can vary, but assessing startups comes with a few common evaluation tactics. VCs will often assess a startup’s management team, the product and where it is in development, the product’s market size, risk and return, and the startup’s valuation.
Startup Founders and Management Team
Venture capitalists have to trust a startup’s management team. In fact, investors’ belief—or lack thereof—in a company’s management can take precedent over their belief in a product or market fit. So what do venture capitalists want in startup management?
Venture capitalists often look for startup teams with prior management or company-building experience. Ideally, some of this experience is in the industry the startup’s product belongs to. Venture capitalists want to see driven, focused managers who have the wherewithal to go beyond mere good ideas.
Product and Development
What the product is and where it is in development can impact whether venture capitalists want to invest or not, and how much they’re willing to invest.
VCs tend to look for products that fill a market need, that solve a problem. They want to see products that other companies aren’t making, or that other companies are selling at a higher price.
Where the product is in development is also important. For example, if only a prototype of the product exists, investors may ask for a larger stake in the company since they’re taking on greater risk.
Market Size
How big is the market the product belongs to? The bigger the market, the larger the potential consumer base—and thus the more money a company can make. Venture capitalists also look at whether the market is growing or shrinking.
Risk and Return
How risky is an investment and how large are the the potential returns? Venture capitalists often look at investments as high-risk-high-reward. This means that the larger risk they’re taking—say, investing in an early-stage startup in an emerging market—the more potential there is for a greater payout down the line. (Of course, it also means there’s a huge potential for no reward at all.)
Valuation
A startup’s valuation impacts venture capital funding, as it helps VCs negotiate how much equity they should get in exchange for a certain amount of investment. Equity often corresponds to how the investment amount relates to the company’s worth. For example, if an investment is equal to 20% of a company’s value, VCs will likely want a minimum of 20% equity.
Venture Capital vs. Private Equity
Venture capital and private equity are often confused, as they both deal with large investments in private companies. But startups only need to worry about venture capital. Below we discuss why that is and explain some other differences between VC and PE.
- Types of Companies
Venture capital and private equity differ greatly when it comes to the types of companies they invest in. Venture capital focuses on startups with high growth potential. Private equity, on the other hand, focuses on established businesses that need a boost or overhaul.While both venture capital and private equity tend to invest in private companies, private equity may invest in a publicly traded company with the intention of turning it private. - Percentage of Ownership
A venture capital investment typically funds 50% or less of a company. VCs generally have some say in company direction and decisions, but they do not have complete steering power. Private equity firms aim to buy 100% of a company so they can have complete control. - Number of Companies in Portfolio
Venture capital firms invest in numerous companies at a time. The risk is spread across entities. Private equity firms typically invest in one company at a time, with resources focused on generating a return from that single investment. - Amount Invested
A single venture capital investment generally tops out in the tens of millions. A single private equity investment might top $100 million. Since private equity gobbles up entire mature companies, there is willingness to invest more in an individual enterprise.
Venture Capital FAQs
How do I get venture capital funding?
Getting venture capital funding requires ample research and networking. Since a venture capital firm typically invests in startups at certain stages of development/growth and within specific industries, it’s essential to seek out firms that fund companies like yours. After establishing which firms to target, consider having a mutual acquaintance introduce you with the firm or attending events that are likely to make that connection possible. If all else fails, it might be time to send a clear and succinct pitch email to the firm.
Does my company need venture capital funding?
Not necessarily. While many startups seek venture capital funding, not all do. Some prefer to take out loans in order to generate funds while maintaining full control of the business. Before taking venture funding, it’s important to do substantial research and talk to trusted advisers.
Are there downsides to accepting venture capital?
Accepting venture capital funding generally coincides with giving away an ownership percentage of your business. Some may see this as a downside, as it means you have to relinquish partial company control. If you decide to pursue venture capital, it’s important to make sure your business is ready for any funds that come your way. Plenty of startups have faltered under the weight of too much money coupled with too little experience.
How much equity should I give to venture capitalists?
There is no easy formula to determine how much equity should be given to venture capital investors over time. Most founders hope to retain as much equity as possible while still getting the investments needed to grow the company. For venture capital-funded startups that reach an initial public offering, founders might have anywhere from a few percentage points of ownership at the low end, to around 40% at the high end. (There are outliers, of course.) Remember that retaining 40% equity doesn’t necessarily mean VCs have 60%; ownership might also be held in employee stock options or by non-VC investors.