Venture capital (VC) and venture capital firms are very important in the world of startups, so it’s vital for startup founders to understand how they work and their potential benefits.
Knowing what venture capital is and how VC firms work can help you decide whether or not VC funding is right for you and your business.
What Is Venture Capital?
Venture capital is a form of private equity financing that is typically invested in early-stage startups and small businesses that have long-term growth potential.
This capital often comes from venture capital firms, wealthy individual investors, and investment banks. Venture capital firms, which manage significant venture capital funds, are the most common source of this type of private equity.
There is typically a high-risk, high-reward potential associated with venture capital, and venture capitalists know that not every project they back will give them a return on their investment.
However, the projects that do succeed are often so lucrative that the high returns more than makeup for losses in the long run.
Since venture capitalists have a lot riding on their investments, the investors often participate in decision-making and provide professional guidance to the companies they back.
In fact, many VC investors are former entrepreneurs or industry experts themselves. They often tend to back projects in areas they have experience in, so they can better guide them to success.
How Does Venture Capital Work?
Venture capital is most often given to individual entrepreneurs, co-founders, and early-stage startups as a way for them to continue developing their products and kickstart growth.
It can be given to companies at different stages of their growth. Many startups receive venture capital funding years after being founded until they get acquired or go public.
In order to receive venture capital, a startup’s founders have to pitch their product idea to potential investors and convince them that it has a high potential for growth and profit.
Although this used to be a somewhat informal process, the venture capital industry has evolved so much over the last few decades that most VC firms now have formal application processes for anyone who wants to pitch an idea to them for funding.
When VC investors look at a potential investment, they analyze the business idea and plan. If they think it has a high potential for success, they conduct further due diligence on the business model, the product, the co-founders, and everything else about the company.
Suppose a pitch is successful and investors want to give a startup venture capital. In that case, they will offer the startup’s founders a sum of money in exchange for a certain percentage of equity in their company.
The end goal of venture capitalists is to sell their equity in the companies they invest in, usually when they go public or are acquired, in exchange for massive returns.
Stages of Venture Capital
As mentioned earlier, venture capital funding can be given to companies at different stages in their evolution.
The stages of VC funding are generally divided into three categories: seed round funding, early-stage funding, and late-stage funding.
Seed round funding is the very first round of VC funding. During this type of round, VC firms usually offer a relatively small sum of money to help brand-new startups work on their business plans and create an MVP if they don’t already have one.
Early Stage Funding
Early-stage funding is divided into three separate funding rounds: series A, B, and C. These funding rounds are what startups use to spur on their initial growth and earn revenue after they have an MVP and some traction.
Investors typically offer much more during early-stage funding than they do for seed round funding.
Late Stage Funding
Late-stage funding is divided into three funding rounds: labeled series D, series E, and series F. Startups usually get this type of venture capital funding when they are already generating revenue and need more funding to continue expanding their operations.
Companies seeking late-stage venture capital don’t necessarily need to be profitable yet. Still, they should have a very positive outlook and the potential to be profitable in the near future.
What Are Venture Capital Funds?
A venture capital fund is a type of private equity fund that’s structured as a limited partnership. Essentially, investors can put their money into a joint fund for investing in early-stage companies, and each person who contributes to the fund is designated as a limited partner.
A single partner manages venture capital funds, called the general partner, and decides what companies to invest the fund in, based on specific criteria.
In other words, the general partner essentially puts the limited partners’ money to work for them, with little effort needed on their part.
VC fund investment criteria may include things like growth and liquidity benchmarks, market position, uniqueness of the product or service, and strength of the company’s management team.
Many venture capital funds focus on investing in specific sectors or industries. For example, there are clean energy, health care, and IT funds.
When venture capital funds get invested, they take a minority share of equity in return.
They then aim to grow the value of this equity and profit by selling it to another company (through an acquisition) or by taking the company they invested in public (through an IPO) and selling their shares on the market.
When a venture capital fund makes a return on an investment, the profit is split between all the limited partners, and the general partner earns a management fee in addition to a share of the profit.
How Do Venture Capital Firms Make Money?
As discussed above, venture capital firms make money in two main ways: by collecting management and performance fees.
VC firms collect management fees no matter the investment outcome, which is usually about 2% to 2.5% of the total funds they manage. These management fees are typically collected annually and cover operation costs and other expenses.
VC performance fees are calculated as a percentage of the profits from profitable investments. Venture capital firms usually collect 20% of the profits for funds that surpass predefined performance benchmarks.
This business model of venture capital firms is often referred to as the 2-and-20 rule.
Some of the most well-known venture capital firms are:
Accel was founded in 1983 and is based in Palo Alto, California. The VC firm has backed many successful companies over the years, including Atlassian, Braintree, Cloudera, Dropbox, Dropcam, Etsy, Facebook, Qualtrics, Slack, Spotify, Supercell, and Vox Media.
Andreesen Horowitz was founded in 2009 in Menlo Park, California. The fund invests in enterprise IT, gaming, social media, e-commerce, and cryptocurrency and has backed companies, including Airbnb, Asana, Facebook, Pinterest, Lyft, Robinhood, and more.
DN Capital was founded in 2000 in London, England. The VC firm invests in software, fintech, mobile apps, digital media, and e-commerce. DN Capital's portfolio includes companies such as Shazam, Remitly, Quandoo, and Leapwork, to name a few.
Like Andreesen Horowitz, Sequoia Capital is also based out of Menlo Park, California, and is one of the top global VC firms. It’s also one of the older ones out there, having been founded in 1972.
Sequoia Capital invests in early-stage and growth companies across various industries, with a big focus on tech. Some companies it has backed are DoorDash, Zoom, Apple, Airbnb, Square, Stripe, Instagram, and WhatsApp.
If you’ve heard of just one of the VC firms on this list, it’s probably Y Combinator. Founded in 2005 in Mountain View, California, Y Combinator is regarded as one of the most successful VC firms and has pioneered new ways of investing venture capital.
Y Combinator has backed thousands of companies since the early 2000s, some of which were Airbnb, Coinbase, Cruise, DoorDash, Dropbox, Instacart, Quora, Reddit, Stripe, and Twitch. Y Combinator invests in many early-stage companies through its startup accelerator program.
Angel investors are wealthy individuals who invest their own money in startup ventures, whereas venture capital investors operate as part of a venture capital firm or fund.
In general terms, angel investors and venture capital firms are two different types of venture capitalists, but angel investors take risks on their own, rather than as part of a bigger company.
Just like VC firms and funds receive a minority stake in companies they invest in, angel investors also negotiate a deal with the companies they invest in for a percent of equity.
If you’ve seen the television program Shark Tank or its British equivalent, Dragons’ Den, you’ve seen angel investors at work.
Investors like Mark Cuban and Lori Greiner on Shark Tank, and Peter Jones and Deborah Meaden on Dragons’ Den, are perfect examples of angel investors.
These individuals are wealthy business people who have earned their fortunes through different business endeavors. They now invest that money in other ventures, looking to help young companies grow and make significant returns.
Venture Capital vs. Private Equity
Venture capital is a type of private equity. The biggest distinguisher between venture capital and private equity in a broader sense is that venture capital is always invested in startups and early-stage companies. In contrast, private equity can also be invested in established enterprises.
Non-venture capitalist private equity investors like to look for established companies that are in financial distress, and usually look to receive a majority stake in the companies they invest in.
Since they often receive more than 50% equity in the companies they back, non-VC private equity investors also tend to take a more active approach to managing and operating the companies in their portfolios.
On the other hand, since venture capitalists don’t typically own a majority stake in their portfolio companies, they provide some guidance to management but don’t usually play a huge role in day-to-day operations.
That being said, private equity and venture capital investors share the same goal at the end of the day: to increase the value of the companies they invest in and sell their stakes at a profit.
What Is the Usual VC Investment Process?
Before venture capitalists even meet with a startup’s founders, they generally conduct some pre-screening process to select proposals that meet their VC company’s standards.
Startup founders and early-stage business owners seeking venture capital funding have to fill out an application and provide a variety of information about their company for pre-selection.
For example, they have to send information about their product or service, business model, management team, and any revenue they are already generating.
Basically, anything that shows their company has potential for growth and profit and meets certain criteria can help land a meeting with VC investors.
After VC firms select successful applicants, they schedule meetings with the founders or co-founders to review their business plans and hear their pitch. This is when startup founders have a chance to share their pitch decks with investors in person.
If the meeting goes well, the venture capitalists then do further due diligence and look closely at all aspects of the company, including the team’s background and financials, to ensure everything checks out and that they are not being misled in any way.
The investors will also do a deep dive into the industry to look at competitors and the current market to better understand growth and profit potential.
After that, VC firms move on to negotiating their investments. They’ll start by offering a certain sum of money in exchange for a certain percentage of equity. The company’s leadership might then make a counteroffer if they don’t like the terms of the initial deal proposed.
Once the venture capitalists and startup founders agree on a deal, they draw up and sign all the required legal documents to make the partnership official.
The legal paperwork includes all the details of the deal, including the amount and terms of the investment, the composition of the board of directors, exit plans, and what matters require the approval of the venture capitalists, such as asset sales and acquisitions.
The whole VC investment process can take up to three months or more, although many deals are closed in just two to eight weeks.
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Pros & Cons of Venture Capital Funding
As with all types of funding, there are pros and cons to receiving VC funding.
Some of the biggest pros of venture capital funding are rapid business growth, access to business expertise and extra resources, valuable connections, and no obligations to repay the money received.
The main cons of venture capital funding are a loss of complete control over the company and potential conflicts of interest.
Pro: Rapid Growth
The most significant benefit of getting venture capital funding is that it can help your company grow much faster than possible if you were to continue bootstrapping it.
Venture capital gives startups access to sums of money that would be very hard or even impossible to come by otherwise.
With all these funds available, early-stage businesses can hire new team members, rent office space, buy equipment, invest in marketing and advertising, and pay for whatever else is required for them to grow.
Pro: Expert Guidance and Additional Resources
Another huge benefit of making a deal with venture capitalists is that you get access to their business expertise and guidance, as well as additional resources they may have to offer, such as office space, equipment, or finance and legal teams.
Since venture capitalists make nothing if a company they back fail, they go above and beyond what’s required of them to assist startups in their portfolio and help ensure that they thrive.
For very early-stage companies, which sometimes only consist of the co-founders, this access to extra guidance and resources can be just as valuable as the venture capital funding they receive.
Pro: More Connections
Venture capitalists typically have extensive networks of other investors, entrepreneurs, and business people in different industries.
They may be able to connect startup founders with potential team members, partners, and private investors.
Pro: No Repayment Required
Another considerable benefit of seeking out venture capital instead of taking a loan of some kind is that you are not obligated to pay it back if your company fails.
Although this is a huge risk to the venture capitalists themselves, it makes venture capital funding much less risky than other types of funding for those on the receiving end.
For comparison, a private business loan has to be paid back no matter what, with interest of about 3% to 7% on top of the initially borrowed sum.
Con: Loss of Control
Since VC firms always take some percentage of equity in a company in return for providing funding, it means that the founder or co-founders no longer have 100% control over their company.
Even if VC partners only hold a minority stake in your company, they will want to have some level of involvement in significant decision-making. They will also have certain rights outlined in the venture capital contract.
In fact, most VC deal contracts specify certain scenarios in which the venture capitalists have to agree with the company’s other stakeholders for them to make a decision, such as selling or acquiring assets.
The size of the stake given to a VC firm usually determines how much influence they have on the company. For instance, venture capitalists with a 30% stake will be much more involved than those with a 10% stake.
Con: Conflicts of Interest
Another issue that can arise with venture capital funding is conflicts of interest.
For instance, unless there is something in the contract that says they can’t, the venture capital firm that backs your company might also be providing funding to a competitor, which can complicate things.
How To Apply for Venture Capital
If you decide that raising venture capital is right for you and your startup, these are the main steps you need to take to help you raise VC funding:
1. Determine Business Valuation
The higher your company’s valuation is, the more venture capital funding you can potentially raise. Your business’s valuation also determines how interesting it is to potential investors.
So, the first thing you need to do before you apply for venture capital funding is estimate how much your business is worth.
There are different ways to do this, and the method can vary depending on the type of company you have and what industry you’re in.
But, in general, you will want to use some statistical or financial modeling to valuate your business.
2. Determine How Much Funding You Need
The next thing you need to do before you start applying for VC funding programs is to decide how much funding your business needs.
It’s a good idea to come up with several different numbers and create separate plans around each of them for what you will do with that funding.
For instance, you might start with a small sum that will allow you to build your first MVP or build a second version of your product prototype.
You could then create a plan around a second, slightly higher amount that will let you build your product, as well as hire some key team members to help you develop it, as an example.
3. Build a Pitch Deck
Once you have estimates of how much your company is worth and how much VC funding you need to raise, it’s time to build a pitch deck.
Your pitch deck should cover all the critical points of your business plan, including what problem your product or service is solving, what the market is like, who your competition is, who’s on your team, and your projected financials.
It would be best if you aimed to cover all this in no more than 12 to 14 slides, giving a high-level overview of your business without going too in-depth on anything. Potential investors can ask you follow-up questions if they want more information.
With your pitch deck built, you can start compiling a list of VC firms from which you want to apply for funding.
You’ll want to look for venture capitalists that invest specifically in businesses in your industry or companies across many different industries.
Some VC firms only offer venture capital for companies at certain stages of growth or in certain locations, so make sure you take these factors into consideration as well.
Once you have a solid list of potential VC investors, prioritize them by how likely you think they are to invest in your company.
5. Apply and Pitch
After you have your prioritized list of potential venture capitalists, you can finally start applying to their funding programs.
VC firm websites have instructions for how to apply or indicate who to contact about applying. So, follow the steps and try to get meetings with VC firms to pitch your startup idea for funding.
If investors like you and your company and think it has potential, they’ll make an offer, and all that’s left to do is negotiate the terms of the deal!
The Bottom Line
If you’re looking for funding for your startup, venture capital is one of the most cost-effective, risk-free options available to you.
VC funding can give your early-stage business the extra push it needs and help it grow rapidly, and working with a VC firm gives you access to additional resources and expertise that you wouldn’t have otherwise.
However, it’s important to know that VC fund application processes are very competitive, so make sure you have a strong business idea and pitch before applying.
What Is Venture Capital?
Venture capital is a type of private equity funding given by venture capital firms or funds to startups and early-stage companies with high growth potential.
How Does Venture Capital Work?
Venture capitalists invest capital in exchange for equity in a company. They usually take a minority stake and have limited involvement in the company’s management.
How Do Venture Capital Firms Make Money?
Venture capital firms make money by charging management fees and performance fees, typically following the 2-and-20 rule. This means they charge 2% and 20%, respectively.