If you've ever watched the television show Shark Tank, you know the amount of work and passion business owners put into pitching their companies to potential investors. After careful consideration of each business's product, organization, and growth potential, investors can choose to offer funding in exchange for a share in the company.
The show is entertaining, but it's also a great introduction to the world of venture capital (VC). If you're the owner of a startup business, you may be wondering how you too can access VC to boost your business growth.
Read on for all the information including what venture capital is, what a venture capitalist does, the different stages of capital investments, and tips for determining if VC funds are a good option for your business model...without having to go on television to do it!
What is venture capital?
Venture capital (VC) is a type of financing available to businesses and entrepreneurs. Funders can be individuals or VC firms that look for promising companies to add to their investment portfolio. VC firms manage money from various sources such as pension funds, corporations, foundations, and wealthy individuals. They then invest this capital in exchange for equity or ownership stakes in the startups they select. Their percentage of ownership in the business can range anywhere from a small amount to a controlling stake of more than 50%.
Not all VC support is financial. Venture capitalists often offer businesses expertise in technology, growth strategies, and the company's management in addition to or instead of funding, also for an ownership stake. This expertise can be a valuable asset for a small business.
Venture capital, private equity, and investment banking
Although these terms are often confused, they refer to different types of business funding. It's important to understand the differences before you seek funding for your company.
- Venture capital: Venture capitalists focus mainly on startup companies or businesses with growth potential. The funding amounts can range from a few hundred thousand to a few million dollars, depending on the size of the business and the funding stage. In addition, while VC firms can take a majority stake in a business, it's more common to take a minority interest and support the business's growth through expertise and connections.
- Private equity: On the other hand, private equity investments focus more on mature businesses and can be millions or even billions of dollars. Private equity deals often claim a majority stake in the business and exert more control over business decisions. Furthermore, private equity funding is often invested in companies that are not listed or traded publicly. Occasionally, private equity may invest in a public company by purchasing enough shares to gain control of the firm and then delisting it from public stock exchanges.
- Investment banks: While banks may work with venture capitalists to facilitate funding and many venture capitalists have backgrounds as investment bankers, there are some key differences. Banks offer loans, which come with interest and must be repaid. An investment banker is more likely to lend to companies with an established performance track record, while a venture capitalist may be more willing to take a chance as an early investor in a young business.
Portfolio companies
Portfolio companies are simply the companies that a VC firm has invested in. Different venture capitalists have different goals for the businesses in their portfolios. Some focus on a particular business sector, while others may invest primarily in companies in the early stages of development. Getting to know the portfolio companies of any VC firm you're interested in approaching will help you focus your efforts on those that are the best fit for your business.
What do venture capital firms do?
Some VC investors focus on particular industry segments like the tech sector, biotechnology, internet, software, and green energy. Any business looking to launch, grow, or innovate may be of interest to VC investors.
After investing, the firms make money through profits from their equity stake as well as a management fee charged to investors for managing the fund. Venture capitalists and VC firms are regulated by the U.S. Securities and Exchange Commission and are subject to the same laws preventing activities like insider trading and money laundering as other financial institutions.
Who's who in the venture capital industry
Individual investors
Sometimes called angel investors, some high-net-worth individuals invest their own money into businesses they feel have strong growth potential. Often these investors have a background as successful entrepreneurs, so they may have valuable management and business experience to offer. Angel investments are often smaller amounts made to early-stage companies.
Institutional investors
Many venture capital investors are institutional entities like pension funds, insurance companies, foundations, endowments, and state-owned investment funds.
Venture capital firms
The majority of investors in the VC marketplace are firms, which invest in and manage a portfolio of companies. Within a VC firm, you may encounter people working in many different roles. Let's look at a few of the most common:
- Partner: A senior member of a venture capital firm, a partner has the authority to make investment decisions. Sometimes called general partners, they usually come from the world of entrepreneurship or investment banking. They have legal liability and an obligation to act in the best financial interest of the firm. In addition, some partners are what's known as limited partners. They are investors who provide capital to the fund. They may be institutional investors like pension funds or foundations, but may also be high-net-worth individuals who have limited partnerships with VC firms. Unlike general partners, limited partners don't have a role in the day-to-day operations of the firm.
- Principal: Principals work with partners to identify, evaluate, and close funding deals. They may also be involved with portfolio companies as board members or operational consultants. Many principals will eventually become partners; their experience in the day-to-day work of the firm gives them experience for that role.
- Associate: Associates are junior members of the firm who do tasks like market research, due diligence on potential investments, and analysis of potential deals. Associates may also help with fundraising and managing the firm's portfolio. Many associates have academic training in economics and finance and will eventually become principals and partners in VC firms.
What types of companies seek venture capital funds?
Venture capital isn't limited to one business sector, size, or stage of development. Both small and large companies seek and receive venture capital. However, there are some types of businesses for which VC funding is often a particularly good fit.
New companies make up a large percentage of the businesses receiving VC investment. According to the National Venture Capital Association (NVCA), in 2021, 70% of investments went to early-stage deals. It makes sense that startups and other new businesses have more growth potential than firms that have already cornered a large section of the market. However, there are venture capital firms that specialize in investing in more established companies as well. These companies have proven their market potential and are looking for further growth or innovation.
In addition, certain business sectors are particularly attractive to venture capitalist funding. According to the NVCA, in 2021, 39% of all VC deals were with software companies. Goods and services and biotech are other sectors with high VC interest.
Benefits and risks of venture capital funding
Like any financial transaction, there are pros and cons to venture capital. Understanding both the benefits and risks will help you be a more informed and savvy decision-maker when it comes to soliciting or accepting funds for your business.
Benefits
You don't have to invest as much of your own money. One obvious benefit is that external funding can help your business grow. You can focus your efforts on your company and don't have to worry about its strain on your personal finances.
Venture capital grows your network. When you have the backing of venture capital investors, they're also invested in your success. One of the primary jobs of venture capitalists is building their network, which they can use to help you with finding employees, building client relationships, and identifying valuable partnerships for your business.
You get access to information and expertise. The venture capital industry gives businesses access to more than just money. Deals often include access to valuable expertise in business skills, managerial strategy, and networking.
There's no need to repay VC funding. Unlike a loan, venture capital investments aren't meant to be repaid. The money is yours to use for building your business in exchange for giving the VC firm or investor an ownership stake. In addition, unlike traditional bank loans, there's no need to put up collateral.
Your business may have improved valuation. The portfolio companies of a venture capital firm can benefit from the firm's network and reputation, which can increase their valuation. Other potential investors, partners, and clients may be more likely to do business with a company that has a well-regarded VC firm behind it.
Risks
Funding decisions can take a long time. Before you receive any venture capital funds, you'll have to do some research and preparation, meet with investors, go through due diligence, wait for a decision, and make sure all of the paperwork is taken care of. If you're looking for short-term funding or need money more quickly, another funding source like a loan might be a better idea.
You may need to accept VC involvement and influence. Selling an ownership stake in your business means that you're giving up some control. While VC advice and guidance can be a benefit to many companies, not everyone wants to accept input on the way they run their business. Make sure you know what level of involvement any potential investors will have before giving up any equity.
Getting funding can be a lot of work. Before they invest in your business, a venture capitalist will want as much information as possible to make sure they're investing wisely. This often means you'll have to provide financial reports and other supporting documents in addition to researching VC firms and meeting with potential investors. That's time that could otherwise be spent building your business.
There can be pressure to grow quickly. Growing a small business is already a high-pressure situation. A VC partner makes money when your business grows, and the faster your growth, the faster they recoup their investment and make a profit. Fast growth can be good, but growth that is too fast can sometimes lead to mistakes and risky decisions.
The stages of venture capital funding
There's a common misconception that venture capital firms only fund new or startup companies. However, venture capital funds are available for enterprises at all stages of development, whether it's a new business just getting off the ground or an established business seeking additional capital for growth.
In addition, many companies go through multiple rounds of funding at different stages of their development. Read on to understand the different stages of funding and how they can support a variety of business models.
Pre-seed funding
Even before a business officially launches, there are costs and expenses. Pre-seed funding gives entrepreneurs financial and expert support for writing a business plan, doing market research, and developing the business's products.
Entrepreneurs often wonder when the right time is to seek pre-seed funding. There are no rules, but it's helpful if a business has a few elements in place before this step. These include a minimum viable product (sometimes called an MVP). This is a basic version of the product that will allow investors to evaluate its potential in the marketplace.
Pre-seed funding is also a good fit when a business is ready to start building a team. In addition, this funding stage can help a company get a good sense of the demand for the product and maybe even a database of potential customers through mailing list signups or preorders.
Seed-round funding
As the first major funding round for most companies, seed-round funding is designed to move a startup with a strong concept toward full-time operation. It can fund things like further product development or market research. In addition, this stage often includes mentorship and expertise from investors—a valuable benefit for business owners who may be new to entrepreneurship.
Early-stage funding
In this stage, venture capitalists invest in companies that are already in business but have a limited operating history and room for growth. The money raised in this stage is used to expand the business and is often divided into two rounds. The first of these is called Series A, which involves more money and higher risk and is often grouped together with seed funding. The second is known as Series B, which helps successful companies scale up and expand their market.
Late-stage funding
Finally, late-stage funding is aimed at businesses that need funding for further development and growth. It is often used for expansions that require large amounts of money like acquiring another company, entering a new market, or getting ready to list shares on the stock market in an initial public offering. At this stage, venture capitalists tend to look for lower-risk investment opportunities with already established companies that have a solid operating history.
7 steps to finding and securing venture capital funding
Starting a business takes a lot of work! And that's without trying to obtain VC funding. While finding and acquiring VC funding can seem daunting, taking things one step at a time will make the process easier, especially for new companies getting into venture capital markets for the first time.
Step #1: Decide if VC funding is right for your business
Venture money can be a great solution for entrepreneurs struggling to raise funds for a startup. But you should keep some of the risks and downsides in mind. Are you willing to give an investor ownership stake in your company? Are you open to expertise and feedback along with the invested capital? Can you invest time and effort to find the right VC partnership for you?
Take the time to evaluate your decision so that when you move forward with your pitch to VC firms, you are confident that it's the right path for you.
Step #2: Know your market
Make sure you know the sales potential for your business and how your enterprise serves your market's needs. A venture capital firm will want to know that you've done your research and understand where your product or service will fit into the current market.
Don't forget about potential market growth. VC investors want to find businesses that have strong opportunities for a return on their investment. So be prepared to answer questions about where you see the market going and how your enterprise is prepared to take advantage of it.
Step #3: Research VC firms and investors
It may be tempting to cast as wide a net as possible, but you can save time with a more targeted search for funds. Not every source of venture capital is the same. Research the VC players in your industry and understand the differences between individual investors, private equity funds, and firms. You'll want to know their track record, focus, and portfolio companies to prepare you for the following steps.
Step #4: Perfect your pitch
An important part of getting access to venture capital markets is pitching yourself to potential investors. You'll need to convince them that your business plan, market focus, and management structure show potential for growth and success.
It's common for entrepreneurs seeking VC funds to have a pitch deck—a visual presentation that includes information about your business, the market, your growth potential, and your team. The best pitch decks are informative, professional-looking, and tailor the information to the specific VC funding source you're presenting to.
Step #5: Prep for due diligence
Once you've attracted the interest of a VC, they'll want to do their own research on your company. This process is called due diligence and helps assure potential investors that your business is a solid investment.
Due diligence research will look at financial statements, legal contracts, business plans, operating expenses, and employee records. You can save time by preparing this information so it’s ready to go when requested.
Don't forget to do your due diligence as well. Although you've probably researched VC firms before approaching them, now is the time to dig deeper and understand their past performance. You may even want to talk to the owners of other companies they've invested in to learn about their experience.
Step #6: Determine the terms
Once a VC firm is interested in your company, it's time to deal with the investment contract. Venture capital contracts can be lengthy and complicated. The deal may involve negotiation on areas like equity stake, board seats, valuation, managerial expertise, and funding schedule. You may want to consult a lawyer to make sure the terms of the deal match your expectations and that you're prepared to fulfill them.
Step #7: Close the deal
Once the terms have been negotiated, you'll need to complete the necessary paperwork, receive the funds, and put them to use to grow your business!
For many business owners, whether they're seeking funding for startup costs or looking to take a successful business to the next level, venture capital fills multiple needs. With an understanding of how venture capital works and some preparation, you'll be ready to pitch your enterprise to venture capitalists...without facing down the sharks on television!