What is Venture Capital?
Venture capital is a form of private equity to fund startups and emerging businesses. A venture capitalist (VC) is always looking for ideas that have the potential for long term growth. A VC invests alone or through an investment company focused on finding the next big thing.
Private equity provides money to larger proven companies. Venture capital fund small innovative companies. It’s a high-risk business but most investors expect to double their money. The funding cycle is around 3 to 4 years and the average return is 25%.
Stages of VC Funding
Venture capitalists tend to focus on industries in their area of expertise. Those who made their money in tech invest in tech startups. When you are looking for investors to pitch, make sure you choose the right playing field.
There are five stages of investor funding:
- Seed stage: It is not typical for a VC firm to fund at this stage. A project in the Seed stage is a concept. There’s no prototype or actionable product or service. If the business is funded, the amount will be limited.
- Startup Stage: Market research has been conducted and there is a prototype available. Money is necessary to get the company off the ground. The startup applies the funding to adding necessary staff or improving the prototype. The funding level is higher than the Seed stage but not by much.
- Early Stage: The company has a proof of concept and some evidence of success. VC funding scales the company’s sales and outreach. The funding is substantial in this stage as investors seem high potential for a positive ROI.
- Growth Stage: The company is already hot, and VC’s want in. The funding levels are the highest yet. Because the investors are late to the game, they get less of a cut. The influx of cash helps with scaling the business with new products and markets. A Growth stage company is making money and close to profitable.
- Bridge Stage: This is the last step before an initial public offering (IPO). VC funding supports acquisition to build capacity. The money is used to reduce costs, lower pricing, and prep for the IPO.
How does Venture Capital work?
There’s an adage that VCs are looking for smart people with great ideas. That may be true, but only if they fall into the right industries. The projections of an industry’s growth rate is a key factor in deciding where VCs put their money.
This chart from the US Bureau of Labor Statistics shows projected industry growth. Healthcare is forecast to grow in several fields. Startups that focus on growth areas will have an easier time attracting funding.
Venture capital isn’t only for startups. Many VC invest in R&D at proven companies. Right now, companies developing therapeutics or a vaccine for the coronavirus are hot prospects. They present the perfect opportunity. The healthcare industry is surging and there’s an urgent need for the products.
The race is on – the risk lies in picking the winner.
Traditional VCs rarely involve themselves in the beginning stages of the funding process. The timing of their involvement is based on risk and reward. The earlier they get in, the more they can get for their money.
But the earlier they get in, the more risk they face. Most VC invest during a startup’s adolescence – when they see evidence of viability. VC funding is used to scale up the business and expand its capability. The goal is to get in as the firm starts to commercialize and maintain an upward trajectory.
Ideas are cheap. Everyone has an idea. They want a viable business model with proven eecution from the founders.
Disruptors are entrepreneurs who flip industry standards on their head. Airbnb disrupted the travel industry. They rejected the notion hotels are the only source of lodging for people on vacation. They empowered homeowners to rent their houses online. Consumers embraced the concept.
Disruption is often highly prized by VCs. They understand the potential return when ideas of this type catch fire. Because these investments are very high risk, they offer less money and want more for it.
Conservative investors did not think people would let strangers into their homes. VCs thought otherwise. They were rewarded for taking risks on business models that seemed impossible.
Entrepreneurs can work harder on their pitch than their business plan. It’s not a strategy VCs appreciate. They want to see a company, not a concept. A good business plan includes a simple summary of the business. The body of the document includes market research, scalability, and management capabilities.
Keep your plan factual and concise. VC firms get tons of these. They don’t need your whole life history, they want to know if investing with you will make money. There is a great free library here on funding and also a validator for vetting your idea.
Get expert advice on how to develop your business by engaging with an incubator. Incubators provide mentoring and guidance for startups and small businesses. The programs are free, but you need to vet them carefully. Some demand too much involvement and muddle the progress. Find incubators here.
Know how much money you need and be prepared to ask for it. When you don’t have money, asking for large amounts can be intimidating. A good business plan has the amount you need – backed up by data.
Don’t assume shaving money off that number will help your case. It might even raise red flags for investors. They want to see that you know what you’re doing. Ask for what you need. There’s plenty of rejection when you’re looking for funding. There’s no point in shorting yourself early on.
Types of Venture Capital Funding
A venture capital investment group combines personal wealth and institutional funds. For example, a wealthy investor and the manager of a pension fund. They collaborate on how to invest the fund’s capital. The investor is protected to some extent.
VCs don’t only provide money. They offer technology, equipment, and executives to staff or mentor the business.
The earlier a VC invests, the higher the risk. It follows they expect a higher return as well. Despite that, investments at the early stages of a startup will be lower. VCs might be willing to take a risk on the unknown but won’t commit a substantial sum.
1. Seed Funding
Seed funding takes an idea and turns it into a startup. It’s not usually provided by a VC firm. Seed funding is typically an investment by the entrepreneur and his family or friends. Depending on the business model, that can be enough to move the idea forward.
This approach is known as bootstrapping.
Though some VC firms provide seed funding, it’s harder to sell. Seed funding is more attractive to Angel investors. An angel investor is a wealthy individual who can withstand high risk. Unlike VCs, they like to back entrepreneurs in the earliest stages of a startup.
Angel investors expect a stake in the company as part of its return. They often use crowdfunding platforms or create “angel networks” to source opportunities. Crowdfunding platforms present an opportunity to find seed funding. There are many available, but some are more focused on funding entrepreneurs.
During this stage, the startup is often more a concept than a company. VC activity usually starts later in the curve.
2. Series A Funding
Series A funding is where VC firms take notice. The startups are more established and have positive Key Performance Indicators (KPIs.) They have a customer base and are generating revenue. VC funding is an opportunity to scale the company into different markets.
A startup receiving VC funds needs to be clear on how to monetize the business. Their business plan shows a path to grow revenue. This is no longer about the concept – it’s about a strategy to build a profitable business.
The difficulty for startups is capturing the attention of VCs. Even with documented potential, it’s difficult to get in front of the right people. Many startups turn to crowdfunding to Series A funding. Interesting to note that many VCs browse those same platforms.
When it comes to investors, once you have one, more will follow. The average funding provided in Series A is $12.5 million. But less than half of companies with seed funding will get Series A funds.
3. Series B Funding
Series B funding goes to grow proven companies. They are businesses that used their Seed and Series A funding to creates a strong customer base. They’ve demonstrated their ability to monetize and have a plan in place for future growth.
VC funds provide the needed cash flow to fulfill the expansion. This isn’t a startup anymore. It’s a full-fledged business, ready to come into its own. The average amount of funding in Series B is $32 million.
Series B funding allows the company to bring on needed resources. Talent acquisition and recruiting are typical applications of Series B funds. The aim is to scale up the ability to deliver for increased demand.
This funding is often provided by the Series A investors. They are familiar with the company and continue to see potential for a high return. There are also VC firms that specialize in late-stage funding. They look for companies that are ready to explode into the market.
4. Series C Funding
Series C funds make growth through acquisition possible. By now the company understands the features customers appreciate. They see the competition’s offerings and need to step up. Acquiring a small business can spur growth faster than developing new features in-house. Investors encourage speed as long as the growth is sustainable.
Series C funding amounts are in double-digit millions. The sources for investment expand due to the company’s track record. Investment banks and hedge funds are coming on board. Usually, this round of VC funding is the last.
Some companies do pursue Series D and E to pursue their initial public offering (IPO.) This is not the norm. The valuation of companies receiving Series C funds start at $115 million. In most circumstances, they have the financial resources they need.
Before offering any funding, a valuation of the business is done on the business. A valuation is an economic analysis of your company. It reviews the current or projected state.
Intrinsic value captures the projected value. The valuation calculates the potential worth of the business. This is how VCs make decisions about funding.
They consider what a startup would be worth with proper funding. They also look at other KPIs outlined in the business plan. If the potential is high and the strategy strong, funding is easier to get. There are two models for valuation.
Absolute valuation is looking for the “real” number. The model focuses only on the business. Revenue, expenses, cash flow and growth rate need assessment. Relative valuation uses comparisons with similar companies for the assessment. This is the preferred method for investors because it’s easier to use.
According to Investopedia, here are valuation amounts by the funding type:
- Seed: $3 to $6 million
- Series A: $22 million
- Series B: $30 to $60 million
- Series C: $115 million +
These are estimates, but they help guide your startup through the process. Meeting basic expectations reassuring to investors.
Occasionally a startup will move to the public markets. In this case the value is set by the collective wisdom of the market. Valuations may rise or fall from what previous investors thought.
Venture Capital Advantages & Disadvantages
There are always pros and cons to every decision. Here’s our take.
- Source for money
- Funding allows rapid growth
- Not a loan – no repayment
- Mentorship by experts
- Their network becomes your network
- Lots of VCs and VC investment groups
- Can lose control of your business
- VCs buy up shares and own majority of business
- Adds a VC surrogate to your team
- Funds contingent on high ROI
- High-stress schedule to show returns
- Not all funds released upfront
Like any other decision, you need to assess your options. Don’t expect to get money simply because you have a good idea. There is a price to pay for their investment.
Though you may not want to involve strangers in your day to day operations, they can offer expertise. There is instant access to people and organizations that would take years to get on your own.
But any investor will expect to take a piece of the company. Some VCs will be more aggressive about controlling operations. Though few VCs are unscrupulous, all are used to being in charge. If that’s a problem for you – VC funds may not be a good fit.
What is Venture Capital? It’s a tradeoff that can help your company succeed. Be ready to state your terms.
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