Want to make your startup dream a reality? You need capital to successfully run your business. In this blog post, we unveil what venture capital is and how it works in funding startups and small businesses for long-term growth and innovation.
When starting a business, you need capital for your business to take off and sustain its regular operations. Capital is necessary to purchase equipment, supplies, and furniture and pay for employees’ payroll and office rent.
There are different ways to access business capital—one of them is through a venture capital firm. Venture capital is one of those buzzwords that gets thrown around, especially in the startup scene. But what is it really and how does it fit into the equation of starting a business? Let’s find out.
What is Venture Capital?
Startup companies with high-growth potential will need funds to further their business goals. On the other end of the spectrum are wealthy investors who are willing to capitalize on such businesses with a long-term growth outlook.
This capital is what we call venture capital and these investors are known as venture capitalists. Venture capital usually comes from wealthy individuals, investment banks, pension funds, insurance companies, and other forms of investment institutions.
Venture capital funding doesn’t necessarily have to be in the form of money. Sometimes, they can be in the form of managerial or technical contributions.
This investment is extremely risky, as the odds of these startup companies generating high returns are pretty slim.
These investments are also illiquid, so you can’t easily sell or turn them into cash with no considerable loss in value. However, they can also produce above-average returns ONLY if they are invested in the right company.
For venture capitalists, their expected returns depend on the startup’s growth. With the high-risk nature of venture capital, some of these investors are lucky to even recoup their original capital.
The harsh reality is that many of these venture investments are not profitable and are simply written off from the books. Venture capital has grown in popularity among new startup ventures or businesses with inadequate company history as a great source for raising money.
This is true for those with no or limited access to capital markets, bank loans, and other debt instruments. Since venture capitalists have equity in the company they invest in, they can wield their power to influence decisions made by the company.
Private Equity vs. Venture Capital
Due to their similarities in structure and concept, it is easy to confuse private equity with venture capital. However, there are striking differences that overlap between these two terms.
They differ in the amount of money, the risk involved, equity percentage claims, and type and sizes of companies they invest in.
Private equity refers to a capital investment provided by investors to companies that are publicly traded or listed on the stock exchange. In essence, equity represents an investor’s percentage of ownership or interest in the company.
A private equity’s source of capital comes from other investment firms and high-net-worth individuals. These investors buy company shares or have financial control over public companies with the aim to convert them to private companies and delist them from the stock exchange.
Private equity firms invest in an existing company with a substantial operating history and expand them further. They buy companies from all industries.
The capital investment may consist of equity and debt financing. These firms usually have 100% ownership in the companies they invest in, which is why they have complete control of the company after the purchase.
A private equity firm’s investments in a single company usually run in $100 million and up. They prefer to pour their investment into a single company as they are already established and mature. This translates to minimal risks when it comes to losses.
Venture capital is capital financing given to startups and small businesses with promising high-growth potential.
Private businesses with no access to public funds may take advantage of venture capital. Venture capital firms support these fledgling companies in the early stages before they do an initial public offering (IPO).
Venture capital firms buy companies from these industries—information technology, clean technology, and biotechnology. Generally, these firms have 50% or less ownership in the companies they invest in.
Considering the high-risk nature of their investments, they prefer to distribute their risk in many other companies.
So, if one investment fails, it won’t have a huge effect on the venture capital fund. These firms shell out $10 million or less for these startups as they are dealing with companies with an unpredictable future (if they succeed or fail).
Role of a Venture Capitalist
A venture capitalist is an investor that provides capital investment to startups or small businesses with a high-growth outlook in return for an equity or percentage ownership of the company.
Such investors risk their time and money on these companies because they may earn a huge return on investment if these ventures are successful. The risk of failure in venture capital is often higher due to the uncertainties involved with new companies with no track record.
Venture capitalist firms are run by a group of partners who have pooled a huge sum of money from limited partners to invest in startups on their behalf. This fund assigns a committee that makes investment decisions.
When they have identified a potential company, they use the pooled money in the VC fund to invest in these companies in exchange for equity or ownership stake.
Generally, VC firms don’t invest in a startup from its inception. Rather, they identify companies at the early stages where they are in the process of marketing their ideas. VCs invest in these firms, cultivate their growth, and then cash out once they hit their ROI.
How Does a Venture Capital Work?
Again, VC firms invest in companies with a high-growth perspective in exchange for partial ownership of the company. To illustrate, a venture capital firm may invest X amount of money for a % stake or equity in the company.
So, a startup company will benefit from easier access to funds while the VC firm gets part ownership in the business. Since they have ownership of the company, these VC firms can also act as a board of directors along with supporting the company’s decision-making process.
From a startup company’s perspective, here’s how a typical transaction with a VC firm rolls out:
- A company starts a business and looks for more funds to grow.
- They approach a VC firm to invest in their company.
- The business owners create a business plan that entails how they are going to generate returns and grow overtime
- The VC firms review their business plan and if they see great potential, they agree among partners to invest in this company.
Venture capital funding goes through 5 stages of funding:
- Start-up stage – Business owners usually fund this stage using their own money as well as capital from angel investors. An angel investor can be family members, friends or wealthy individuals that invest in the company. Angels usually back companies with no sufficient operating history as these are the people that the startup owners know personally.
- Seed or early-stage – This often involves capital investments of $5 million or less to high-growth companies (startups). At this stage, the startup company doesn’t have cash flow yet or hasn’t reached a break-even. Angel investors and early-stage VC funds are usually the ones to offer this type of investment.
- Growth stage – Investments on these stage target companies that are already profitable with a solid business model and profitability. This funding ranges from $5-20 million with a sole purpose to help boost the company’s market share.
- Late stage – These are rounds of capital investments intended for mature and profitable companies that seek to raise more than $10 million investment for specific business initiatives. These funds are often provided by well-established VC firms.
- Bridge/Pre-Public Stage – At this stage, the company may already have gained a massive market share with its products or services. They may opt to go public. The chief reason to go public is for investors to exit the company after cashing in their profits. The company will use the funding for any of these activities: mergers and acquisitions (M&A), a price reduction to eliminate competitors and IPO.
How Do VC Firms Profit?
Venture capital firms make money in two ways:
- Carried Interest – This is the share of profits of the investment fund paid to the fund managers. Carried interest is mostly 20-25%. If 20% of the profits go to the general partners, the rest of the 80% goes to the limited partners.
- Management Fees – Venture capital funds charge an annual management fee for managing the fund. This a way to cover the pay for salaries and operational expenses. VC funds charge investors 2-2.5% of the total fund value per year.
Venture Capital Funding: A Great Source for Innovation
For emerging startups and small businesses with limited access to funding, venture capital can be a great source to grow their business. VC firms help drive innovation as they provide support to companies they invest in.
If you need funding for your business, working with a venture capital firm can be an excellent opportunity to bankroll your startup dream. Just make sure that you do in-depth research before you dive in and talk to a venture capital firm.
To get your best foot forward to potential investors, our Full Scale founders Matt DeCoursey and Matt Watson can help.
On the 6th episode of the Startup Hustle podcast, the Matts had a detailed discussion with Venture360 Founder Rachael Qualls on how to raise f, reach investors, and use technology to keep your funding organized.
Ready to scale up your startup? Consider talking to seasoned experts with building successful startups. We at Full Scale can help you mobilize and grow your startup from the ground up. Get your FREE consultation at Full Scale today.