Venture Capital 101: A Guide For Founders
Last year, more than 17,000 startups received funding from a venture capitalist, amounting to just under $330 billion in investment.
That’s a staggering amount of money; even more when you consider that it’s up sevenfold in just ten years.
So, what’s this all about?
What exactly is venture capital, and why is it so impressively popular? And where is all that money coming from!?
In this article, we’ll discuss the finer details of venture capital, from pros and cons to the state of the industry, and finishing up with a guide to determining whether or not venture capital is the best move for your startup.
Table of contents:
- What is a venture capitalist?
- How venture capital works
- The benefits of venture capital funding
- Venture capital vs. angel investors
- The current state of VC funding
- Why should startups consider venture capital?
What Is Venture Capital?
Venture capital is a type of private equity and financing that investors provide to startups whom they believe to hold high potential for growth.
It’s typically abbreviated as VC, though this acronym can also be used to describe a venture capitalist, as in “a VC”, being a person who engages in such investment.
Whilst venture capital is a form of private equity (PE), the primary difference between VC and other forms of PE is that venture capitalists generally invest in emerging companies, while PE investors more commonly focus on established companies.
Startups most commonly receive venture capital funding from VC firms. These firms raise money from a variety of investors (universities, pension funds, foundations, and high net worth individuals), and then have their staff (the VCs) assess investment opportunities and fund companies who fit their criteria.
Of course, these companies don’t simply dole out money for the love of the game — they’re looking for some form of return on their investment.
This is most commonly received in the form of equity in the startup. That is, for their investment, they now own a percentage of the company, and are entitled to a share of its profits and any increases in value over time.
So, how does this whole arrangement work?
How the Venture Capital Process Works
As a startup, the road to getting funded can be long and bumpy. Not every VC is going to be interested in investing. Indeed, not every company gets funded.
In general, though, the venture capital process (from the startup’s perspective) goes like this.
Approaching Venture Capitalists
The first step is to get in front of potential investors.
This often includes attending industry events, cold outreach to VCs, and reaching out to your network to get a referral.
Psst. Read more about networking with investors here.
Preparing Relevant Documentation
Once you’ve secured a meeting or phone call with a VC, it’s important to make sure you’ve got your financial affairs in order.
Pitching to Your Investor
With your plan and forecasts in hand, it’s time to sit down with a few venture capitalists and show them why you, your business, and your idea are about to set the world on fire.
Sell them the dream, but make sure your pitch is grounded in reality, with accurate financials and a reasonable assessment of competition and threats to your success.
Read more about pitching to investors here.
Negotiating the Terms of Investment
If your idea is sound and your investors are confident in your ability to bring the concept to market, you’ll be one of those lucky 17,000 companies who get funded!
The next step is to agree on the terms of your investment (a term sheet). This involves factors such as:
- The amount of funding you’ll receive
- The investor’s share of equity
- The company valuation
Post-Investment: Expectations and Support
In some cases, venture capital is simply a cash investment. You get the money; they get the equity.
In many situations, however, venture capitalists want to get a little more involved in their investment. After all, it’s in their best interests for your startup to succeed.
This is good news for you also, as VCs often have extensive networks that you can tap into.
Plus, more often than not they’re able to provide solid advice on aspects of foundership such as hiring, strategy, positioning, and product development.
The venture capital arrangement typically ends with an exit, where the VC helps your company initiate an initial public offering (IPO), merger, or acquisition.
Why Do Founders Seek Venture Capital Investment?
This might seem a bit obvious. After all, you need cash to stay in business. While this is true, the details are a little more complicated.
It’s true that not all companies get funded, and there are definitely success stories of businesses going right through to IPO without ever receiving VC funding (known as bootstrapping).
The problem is, this is quite tricky to pull off for a number of business types, particularly software, which is where a lot of VC funding goes.
To get a software product to market, you have to develop it first.
Even in today’s climate, where development can be orchestrated comparatively cheaply, the cost of developing a workable MVP (minimum viable product), and marketing and selling it, can still rack up several hundred thousand dollars.
The challenge with this is that the bill is payable before you’ve even started making revenue.
Contrast this with a service-based business, like a marketing agency.
Agencies can more easily grow unfunded, as they don’t have to create a physical (or digital) product first. They can grow revenue first (i.e., sign a contract with a new client), and add on new capacity as they go (or even rely on freelancers if they want to be super agile).
Product-based companies (including both software and physical products) don’t have this luxury.
The problem is worse for SaaS companies, whose revenue trickles in over a course of months or years.
In previous years (when software was sold more commonly using the perpetual license model), founders could self-fund or secure a loan, bring the product to market, and make significant revenue off the bat (if they marketed and sold it well).
Subscription-based companies receive their revenue spread out over the course of a customer’s lifetime.
Hence, for companies such as this, venture capital funding becomes somewhat of a necessity.
Venture Capital Pros and Cons
Venture capital isn’t a perfect fit for every company.
While getting funded is a huge plus, there are a few drawbacks to consider.
|Venture capital pros||Venture capital cons|
|You can focus on building the right product, rather than growing revenue||You dilute your share of equity|
|You might be able to draw on the expertise and network of your investor||Your investors will likely have a say in the direction of the company|
|You don’t have to pay back the investment (compared to other funding forms such as debt financing)||You might find it difficult to obtain funding|
Venture Capital Firms vs. Angel Investors
While venture capitalists are the most common source of equity financing, there is another way forward that is often more suitable for early-stage companies:
Angels are high net-worth individuals who make similar investments to VCs, but they aren’t part of a firm.
That means they’re investing their own money, rather than someone else’s. Angel investors tend to be more interested in pre-seed and seed round funding, whereas the majority of VCs will wait until Series A and beyond.
Read more about the difference between venture capitalists and angel investors here.
The Current State of Venture Capitalism
While venture capitalism can be dated back to the 1940s, the industry as we know it really kicked off through the 70s and 80s.
As you might imagine, however, a lot has changed since then. Even in just the last decade, the amount of cash flowing from investors to startups has grown more than 7x.
A few of the other noticeable trends in modern venture capitalism are:
- Higher valuations (the average early-stage valuation has tripled in the last 10 years)
- Faster growth expectations (the typical time between initial investment and IPO is less than six years now)
- Easier access to capital (more and more firms are emerging, more deals are being signed, and more cash is being an investment)
- Specialization of VC firms (startups can now work with software-only VCs, for example, how to have industry-specific expertise)
- Continued growth on the West Coast, accounting for over half of the money VCs invest
- Non-VC investors (such as mutual funds and corporate investors) are getting involved in startup funding
When Should Startups Consider Venture Capital?
While venture capital is now fairly commonplace in the startup world, there are still some misconceptions about the concept.
Most common is the belief that VC is the only way forward for startups.
We’ve discussed above some reasons why founders turn to VC funding and outlined a few of the pros and cons of this investment method, but there’s one more factor to consider:
Your growth goals.
Investors are looking for big returns on their money, meaning there will be significant pressure on you and your startup to succeed. While this can be a great motivator, it’s important to note that not all companies have the ability to orchestrate a large exit.
As a general rule, if you’re not trying to build a “unicorn” company (a privately-held company with a valuation of over $1B), taking on VC funding might not be the best idea.
If your revenue model and TAM (total addressable market) predict that you’ll max out at around $5M in annualized revenue, for example, then VC probably isn’t the best fit.
Venture capital is an integral part of the startup ecosystem.
It’s not for every business, but it will be crucial for some, particularly for those who aren’t able to generate revenue quickly.
To impress your investors, it’s important that your financial forecasts and projections are clean, accurate, and realistic.