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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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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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.
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.
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.
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.
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.
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.)
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 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.
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.
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.
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.
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.