What Is Venture Capital and How Does It Work?

So, you've built a product, got your first customers and are now ready to raise money.

You don't have VC's knocking at your door but you're wondering how they work so you can learn more about raising money.

This post is for you.

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. As a founder, this is one of the pros of raising VC.

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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.

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Seed 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.

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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.

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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.

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.

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FAQs

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.

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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.