Venture Capital Definition
What is venture capital and why use it?
How much can a startup raise from a venture capital company?
At what stage of a startup development is the right time to seek venture capital help.
Venture capital is a type of financing that is associated with high-risk investments. It is usually performed on startups or other businesses that have the potential of extraordinary growth in a relatively short period of time.
There are many types of investments that can be vehicles to grow initial capital. The venture capital investment is usually highly speculative and expects hefty multiples.
This explains why startups with venture capital investments need to have a clear exit strategy and actually work towards it from the very beginning. A startup funded by a venture capital firm looks for a form of acquisition of the startup or an IPO.
Why Use Venture Capital
Venture capital is the best option for a startup to scale big fast. This is the key element in raising venture capital – the opportunity to scale, to be able to address the big markets and to be able to do this fast.
The venture capital investment is usually much larger than previous investments. This means your startup needs to be capable to take a big amount of money and grow it. Not all startups are in such a position.
The biggest advantage of engaging with a venture capital company is that you don’t need to pay back the investment if the startup fails. This is the biggest difference with a bank loan. A bank loan is a non-dilution type of funding, but you are 100% responsible to return the money borrowed. Venture capital takes a portion of your company in exchange for providing funds to grow fast.
Another great plus in getting funded by a VC is that VC funds are usually established by very connected people who can help you grow your company. They also may have relationships with other providers that can either provide you service on preferable terms or become your customers.
A disadvantage of using venture capital is that you pay with equity. We discussed already Should You Pay With Equity To Build Your Startup.
In case you really need to scale fast in a big market, you definitely need serious financial help. But once accepting venture capital, founders should be clear that they need to plan for an exit – acquisition or an IPO. If you wanted to create a company that you would run forever – getting funds from a venture capital firm is not for you.
As a founder you should be prepared to give up a significant portion of your company share – in some cases, this means losing the management control of your company.
How Does Venture Capital Work
Venture capital firms manage big funds. They raise a large amount of money from wealthy individuals or institutions. The venture capital firm invests on behalf of the partners providing the funds.
It is good to remember why venture capital companies exist and what their goals are.
The managers of the venture capital have only one responsibility and it is not to you – the founder, it is to the shareholders of the venture capital fund. This responsibility is to maximize their profits and ROI.
With that in mind, it is easy to understand the venture capital firm’s approaches and decisions. To maximize the return, these funds are operating with high-risk investments (startups) with the potential for huge returns (25x or more) and in a very limited period of time.
The big ROI is needed to cover the losses of the high number of failed startups. This simply means that the high ROI is not only a goal but also a necessity for the venture capital firm to survive.
Venture capital firms review thousands of startups every year, but the number of actual investments they make is actually low. VCs are extremely selective in their deals and although they write big checks, they only make a few investments each year.
Selecting a few companies to invest in every year allows venture capital companies to be more engaged and help the startups grow. This is beneficial to the startups because they will be able to get some time and attention from the VC and the stakeholders of the VC fund.
Venture capital firms are very strict in the ways they make their selection. They usually invest in areas they feel comfortable and familiar with. As a founder, you need to do your investigation and focus your efforts on funds that work with your industry.
Depending on the industry and the size of the fund, venture capital firms could write checks as small as $250,000 or as much as $100 million. These are extreme cases. Remember that venture capital looks for sizable investment to enable huge returns. A check in the range of $5 million is the most common investment if you are seeking a “Series A” kind of deal.
Investments up to $2 million are usually considered Seed Funding and the venture capital firms tend to stay on bigger deals. After all, you should have had previous investments that would get you to the “Series A” investment of the venture capital firm.
Preferred Industries By Venture Capital
By its nature, venture capital is seeking for fast returns and high multiples. This characteristic of this type of funding naturally favors specific industries and makes other industries look like “bad investments”.
Technology companies tend to offer scalability (if properly implemented), quick access to huge markets and provide measurable results in a short period of time. That is why technology startups seem to be a favorite topic for venture capital.
Please note that to the venture capital firm it is more important to increase the value of the startup than to build a profitable business. Yes, these are different things, as we have seen in the past.
The potential of a company (earnings and market) has proven many times over to be much more valuable than making big profits. And venture capital is not there to build a great business, it is there to generate high returns for its stakeholders.
Another factor to count in is the fact that many shareholders in these venture capitals come from technology companies. Many technology company founders are later becoming investors and they tend to stick to what they understand.
You may say that the industry feeds itself with new investors who went through the process of funding, building businesses, and exiting successfully.
Venture Capital And Startups
To sum it up, venture capital is created to support and make short-term high-risk investments in companies that can scale fast to serve huge markets.
The main goal of the venture capital managers when investing in s startup is to create a company of high value so they can exit with huge gains (25x and more).
Profitability is not an immediate goal because it doesn’t provide an exit option. Examples of exists for venture capital-funded starts are acquisition and IPO.
VC firms tend to invest in industries they are familiar with and as a result, there is favoritism in investing – some industries and types of startups receive more attestation than others.
In each funding series – “Series A, B, C, D, E” you are giving up equity. It is possible at some point to lose the management control of your company; this has happened many times in the history of startups.
You need to start pitching to venture capital companies if you are close to exhausting your seed funding, have some traction, and need to start driving in some serious revenue.