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Venture Capital funding is money whose source is not from the value of publicly traded shares of a company on the stock exchange but from funds that are entirely owned by high net worth individuals or firms.
Venture capital funding is usually given to emerging companies at the beginning stages of their trajectory that do not have a track record of growth and profitability but can demonstrate that with funding they will grow into a company that will produce high profits and thus a high return for the investor.
These investments are seen as high risk and so they are usually made by people or firms that have much experience in high risk investment environments and not by regular lending institutions that refrain from investments that have a high potential to lose all their original money.
- Venture capital can come in many forms.
- Venture Capitalists will offer their technical knowledge, managerial expertise and financial expertise/connections
- Typically these investors will ask for a large portion of the company.
How Does Venture Capital Work?
Venture capital firms often provide funding to young businesses and startups.
But it’s possible for a venture capital firm to invest at a different stage of the company’s development. With that, a long-standing company standing on the edge of extreme growth would also be a good candidate for a venture capital investment. For example, Greycroft, a venture capital firm, invested in Acorns and Venmo.
The venture capital firm, and its investors, will receive their profits when the company exits through a merger, IPO, or acquisition.
- Structure of VC firms: Venture capital firms are often structured in the form of a partnership that purchases minority shares of companies with growth potential.
- VC firms have a portfolio of companies: Many firms focus on a particular industry to build a portfolio of companies within.
- The profits are split between general and limited partners: The general partners manage the venture capital fund of limited partners, who are the investors that put up the cash. When investment performance profits are received, the limited partners receive 80% of the funds and the general partners receive 20%. Typically, general partners also receive an annual management fee of up to 2% of the invested funds.
- Venture capitalists aren’t angel investors: Venture capitalists manage other people’s money. But an angel investor is a wealthy individual that invests their own funds in startups. See what are angel investors for more details.
Types of Venture Capitalists
Not all venture capitalists are the same, or offer the same opportunities to companies. As you consider your options, understanding the different types of venture capitalists is helpful.
- Definition: Traditional venture capitalists tend to be firms that invest money into growing companies. In general, the funds are invested through a hands-off approach with a predetermined split of the future profits.
- When it makes sense: If you are looking for large sums of money, a traditional venture capitalist might be the right fit.
- Definition: Micro VCs typically invest smaller amounts of money into early-stage companies. In many cases, micro VCs are willing to take on more risk due to the smaller investment amount.
- When it makes sense: Most micro VCs offer more hands-on advice and serves in a mentorship role. But it will only work out if you need a smaller investment.
Stages In Venture Capital Funding
If you want to pursue venture capital funding, understanding the many stages of the process is important. Here’s a look at the process beyond the venture capital funding definition:
- Seed stage: If you have an idea for a business that can't get off the ground without major funding, you’ll need to convince a venture capitalist that the idea has merit. A persuasive founder will be able to convince a VC firm to take a chance on their idea. The funds will be used to develop the product, conduct market research, and set up a team.
- Startup stage: If you’ve already developed a prototype and completed the necessary market research, an investor can provide the infusion of cash necessary to market the product.
- First stage: At this point, your company is starting to manufacture and sell the product. Even with a commercially-viable product or service, you’ll need funding to reach your customers.
- Expansion stage: With enough demand for the product, you’ll start to expand your offerings. But most expansions require additional funding.
- Bridge stage: In this final step, a venture capitalist can help the company transition from a private company to a public company. This is the end goal of all venture capitalists because big returns are possible here.
How To Get Venture Capital Funding
Now that you know what a VC is in business, you might decide that its the right fit for your business. But getting this type of financing isn’t as simple as filling out a loan application. Here’s what you need to do to pursue venture capital funding:
- Research venture capital firms: Not all VC firms are created equally and many focus on a particular industry. With that, take the time to research the firms that might be interested in your company. You don’t want to waste your time trying to work with a venture capitalist that isn’t the right fit.
- Make sure your company is ready: You don’t want to approach a VC firm until you’ve built out a business plan. Although things can always change, a detailed business plan can serve as a roadmap to your company’s future success. If your company is not yet ready you might want to look into an alternative source of funding such as microloans. See what is a microloan for more details.
- Secure a meeting: Send out requests for a meeting to the venture capital firms you want to work with. You can set yourself apart from the crowd with a professional note and an overview of why your company has major growth potential.
- Build a pitch: Start by determining a fair business valuation. Next, build out a pitch deck with professional materials designed to convey your competency. It’s important to tailor the pitch to the specific firm you’ll be meeting with.
- Get through the due diligence process: If a venture capitalist wants to work with you, they’ll conduct a thorough investigation into your company and your past. It’s important to be open and honest about anything that could stand in the way of the deal.
- Negotiate: If you receive an offer from a VC firm, it’s tempting to jump in headfirst. It’s likely you’ll have to part with a significant portion of your company’s equity. So, take the time to make sure the deal is right for your situation. Otherwise, you might regret your quick reaction.
- Move forward with more funding: After the deal is settled, you’ll have the funds you need to grow your business.
What are VC Term Sheets
A VC term sheet is the proposed statement of terms and conditions for an investment by a venture capitalist into a company.
- Length: Typically, these sheets are less than 10 pages.
- Who prepares this sheet? The VC often prepares this sheet with proposed investment terms and presents it to the business owner.
- Is it legally binding? A VC term sheet is the first step of building out a legal contract. The term sheet itself may not be legally binding. But the future contract will be.
What Should VC Term Sheets Include
The details of every VC term sheet will look a little bit different. But as an investor, you can expect to see these terms in the document:
- Investment structure: The details of what the company will give up in exchange for the venture capitalist’s investment.
- Preferred return on investment: The sheet will include the VC’s preferred return on investment. Plus, how the future profits will be split.
- Reporting: Many VCs require detailed reporting from the company over time.
- Board structure: Most VCs will require the company to build out a board with an odd number of directors that represent the founders and investors.
- Closing details: This might include the due diligence requirements and any exclusivity terms between the company and the VC.
Tips On Getting Ready For A Meeting With Venture Capitalist
If you’ve landed a meeting with a venture capitalist, that’s just the first step. Here are some tips to help you nail the meeting:
- Form your business entity: Don’t go to the meeting without setting up your business’ legal entity. Most venture capitalists prefer to work with businesses that are Delaware general corporations with a C status.
- Work with a legal professional: After the initial formation, it’s time to draft a few documents including founder stock purchase agreements, bylaws, indemnification agreements, proprietary information agreements, and stock certificates. The right lawyer can help you wade through these documents.
- Research your industry in relation to VCs: Is there a major growth opportunity? Make sure to have the numbers ready to back up your claims.
- Be clear on what the VC can bring to the table: Most venture capitalists want to utilize their skills and expertise when growing a business. Find out what skills the investors specialize in before heading to the meeting.
- Ask questions about the firm: Don’t assume that any VC firm is a good fit. Take the time to ask questions to decide whether or not the deal feels like the right move for your business.
Who Is Venture Capital Funding Recommended For?
Venture capital funding isn’t the right fit for everyone. But here’s when it could be the right move for you.
- Startups in hot industries: Is there a major potential for growth in the industry? The allure of high investment returns will draw venture capitalists.
- Entrepreneurs with unique ideas: If you have a unique idea that could grow very quickly, venture capital funding could be the right move.
- Entrepreneurs with a solid track record: Have you already built and exited a successful business? Investors love working with someone that has a proven record of business success.
- Market demand: Is there more demand for your product than you can meet? That could mean a big chance at high returns.
If venture capital doesn’t seem like the right option for you, you could look into peer to peer lending. See what is peer to peer lending.
Pros And Cons Of Venture Capital Funding
All funding types come with advantages and disadvantages. Let’s look at the pros and cons of venture capital funding.
Starting with the pros:
- Access to the funding you need: Venture capital can be the infusion of cash your business needs.
- Professional guidance often available: Most venture capitalists provide expertise and advice as you grow your business.
- Long-term funding potential: Although not always the case, many venture capital firms will build long-term relationships with successful entrepreneurs.
Now for the cons:
- Competitive space: It can be challenging to obtain funding through this option based on the extensive competition.
- Low chance of funding: Less than 10% of presented plans actually receive funding.
- Must give up some equity: If you want to maintain full control over your business, this is not the right move for you.
Alternatives to Venture Capital Funding
Venture capital funding isn’t the only way to get the money you need to grow your business. If you don’t want to pursue venture capital funding, consider the following alternatives:
- Venture debt: Instead of accepting an investment from a VC, you could take out a loan from a VC firm.
- Angel investors: Individual investors with enough capital sometimes invest in growing businesses. Typically, they take on a mentorship role as the company grows.
- Personal savings: If you have assets or savings, you might choose to liquidate them to fund your business.
- Borrow from friends and family: It’s sometimes possible to raise funds from friends and family. But consider the strain this might put on your personal relationships.
- Crowdfunding: If you have a business that excites the average consumer, crowdfunding could be an effective solution.
- Business loans: Many lenders offer business loans. Make sure your business can afford to take on the new monthly payment before finalizing the loan.