Venture Capital Definition & How It Works

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KEY TAKEAWAYS

• Venture capital is a form of financing that’s given to small businesses and entrepreneurs. Sometimes it can come at different stages of business growth but typically involves early funding.
• Venture capital has evolved over the years into a sophisticated industry. There are several venture capital firms that play a critical role in the evolution of innovation.
• It doesn’t always come in monetary form. Sometimes venture capital can be provided in the form of managerial or technical expertise. 

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What Is Venture Capital? 

Venture capital is a type of private equity that an entrepreneur can explore as funding. It’s a specific form of financing that allows investors to provide startup companies and small businesses with the capital they require. They do this because they believe the businesses have long-term growth potential. 

Typically, venture capital will often come from the likes of investment banks, wealthy investors, and other financial institutions. That said, it’s not always necessarily in monetary form. Sometimes venture capital can get offered in the form of managerial or technical expertise. 

More often than not venture capital will get allocated to startups that have exceptional growth potential. Either that or companies that have grown at a rapid pace and are on the verge of expansion. 

Investors like to offer venture capital because the possibility of above-average returns is an attractive end goal. However, not all investments turn out the way they might be expected to since there is always a risk of failure. 

But with all that said, venture capital is becoming incredibly popular as a source for raising funds. This is since it can often be difficult to access bank loans or capital markups without a history. 

How Does Venture Capital Work?

If an entrepreneur or small business obtains venture capital, it usually happens by offering ownership stakes in the company. These stakes are offered to investors that are typically part of venture capital firms. However, sometimes these independent limited partnerships can consist of multiple enterprises. 

There’s an important distinction between venture capital and private equity. Venture capital deals usually focus on up-and-coming and emerging companies that need substantial investment dollars for the first time. They’re often looking for help getting to the next stage of business growth. 

On the flip side, private equity typically consists of a larger and more established company. These companies are looking for some type of equity infusion or a transfer of ownership stakes. 

The Venture Capital Process

If an entrepreneur or small business is looking into venture capital, the first thing they’re going to need to do is to submit a business plan. This can be to either an angel investor or a specific venture capital firm. 

After this and if investors are interested in the submitted proposal, they will perform their own due diligence. This is to ensure that the investment would be a viable opportunity and doesn’t pose any big risks. 

Most venture capital investor types have a well-balanced history of investment experience. Some have been equity research analysts and others have a degree in Master in Business Administration (MBA). 

Once they have conducted their due diligence and are satisfied with what they found, they will likely make an offer. This will come as a pledge of investment of capital to receive equity in the company in return. 

It depends on the specific situation, but sometimes funding can get provided all at once. But more often than not, the funding gets provided in different rounds. After this, the investor of a venture capital firm will often take an active role in the business. 

They will monitor the process and provide advice as it progresses. The investor doesn’t stay forever though. After an amount of time passes from the initial investment, they might initiate a merger, initial public offering (IP), or an acquisition. 

Stages of the Venture Capital Funding Process

The funding process may vary according to the situation. However, most venture capital funding follows 5 general stages. Let’s take a closer look.

Introduction

In the world of funding, introductions are important. Venture capitalists may receive thousands of pitches a year and meet with hundreds of prospective startups. A quality introduction ensures that your pitch will be taken seriously. 

Submit Pitch Deck

If there is interest in your project, you’ll be asked to submit a pitch deck. The VC will review the deck and decide whether to proceed further. If they believe there is potential in your project, you’ll be called in for an in-person meeting.

Term Sheet

A term sheet is a non-binding agreement that lists possible funding offers. If a VC firm is interested in funding your project, they’ll submit a term sheet outlining their proposal.

Due Diligence

This is a critical step in the funding process. Venture capital firms will conduct rigorous due diligence and look into your business and legal history. If they’re satisfied with what they see, they may submit an offer. 

If not, they will reject your application. Sometimes, they’ll offer to mentor startups that don’t pass the due diligence process in exchange for equity.

Decision

If you’ve made it to this point, congratulations. The VC firm will submit an offer for you to accept or reject. Only take the offer if you feel they’re asking for a fair amount of equity in your company. If you accept, they’ll begin funding your project and you will become venture capital partners. 

Most funds are distributed in several rounds. The firm will monitor your progress and dispense additional funding rounds if their expectations are met. 

Why Is Venture Capital Important? 

A capitalist economy is built on the backs of innovation and entrepreneurship. But even with that being the case, not all new businesses are going to become successful. New businesses can often be cost-intensive and high-risk ventures. 

This is one of the main reasons why external capital is looked for since it can help spread out any possibility of failure. In return for their investment, investors can obtain certain amounts of equity and even voting rights. 

That’s important to recognize because they can typically acquire these rights at a much cheaper rate. All of this works hand-in-hand, as startups are able to get a boost to get off the ground and scale their business to the next level. 

How Risky Is a Venture Capital Investment? 

Every type of investment will often come with some sort of risk. But since a lot of new companies don’t succeed, investors run the risk of losing their initial investment. 

This is a big reason why venture capitalists and angel investors will conduct due diligence prior to offering to fund. It isn’t a perfect recipe or fail-proof, but it allows investors to know what they’re getting into. 

Almost thirty to forty percent of startups fail completely without getting to the next level. From here, there’s an additional thirty to forty percent that don’t see any type of return from the original investment. This leaves around ten to twenty percent of startups that actually see substantial returns on investment. 

Why Does Venture Capital Exist?

Venture capital exists as a funding avenue since new companies might not have anywhere else to turn for funding. Since most startups are a risky endeavor, banks are hesitant to offer large loans. New businesses can generally only secure a bank loan if they have hard assets to give up as collateral. 

This is a challenge for the majority of startups with no hard assets who need to find a funding source or an increase in funding levels. 

In contrast, venture capital firms are willing to take on a high level of risk in exchange for a significant stake of ownership in a company. If the company gets bought out later, the VCs make a large profit.

Still, most VC firms hedge their bets by having a liquidation preference. This means that the VC firm has the rights to the company’s assets and technology if it fails.  

Different Types of Venture Capital

Venture capital comes in many different forms. Each deal is different and depends on the situation. However, these are the most common types of venture capital. 

Seed Capital

This type of funding helps new startups get off the ground. Many of these companies won’t yet have a fully developed product or a running operation. The seed capital helps fund product development, hire a team, and conduct market research.

Startup Capital

If a new company has a developed product but needs help breaking into the market, it may be eligible for startup capital. 

Early-Stage Capital

This type of capital is for companies that need to improve and streamline their business activities. They will likely have a product in the market but need extra money to fuel growth.

Expansion Capital

For well-developed companies with several years of experience, expansion capital can take them to the next level. It’s used to fund marketing campaigns, new product development, and other growth strategies.

Late-Stage Capital

This type of capital is for successful businesses that need a boost in cash flow. The company might use it to grow its existing operation to make it more attractive to buyers. 

Bridge Financing

When a company is on the verge of an IPO or a merger, it may need bridge financing to keep operating at a high level. This is often a more temporary fix than a long-term solution.

Benefits of Venture Capital

There can be several benefits that can come from venture capital. And it isn’t limited to one side versus the other. Both entrepreneurs and investors can see advantages. Here are some of the most common benefits of venture capital. 

Investors Can Make a Significant Profit

The primary goal of venture capital is to fund companies that will sell for a high profit later on. While it’s a risky strategy, many of the world’s most successful companies were initially funded by venture capital.

Available for Startups that Don’t Have Hard Assets

Venture capital is available to startups without access to other sources of funding. Without any hard assets, a bank is unlikely to take a risk on a new business. This makes VC funding very attractive to entrepreneurs. 

Access to Industry Experts and Key Networks

This is often just as valuable as the money itself. Venture capital firms contain successful entrepreneurs that can guide new companies toward success. VCs usually sit on the board of directors and facilitate industry connections and key partnerships.

Drawbacks of Venture Capital

While venture capital can bring several benefits to everyone involved, it can also see some drawbacks. Here are some of the most common drawbacks of venture capital. 

Risky for Investors

The reality is that most startups fail within the first few years. As a result, venture capital firms 

assume a high risk by investing in companies without any proven success.

Loss of Equity

VCs ask for a high amount of equity to justify taking on the risk of investing in an unproven business. Entrepreneurs must decide if they’re willing to give away up to 50% or more of their company in exchange for capital.

Loss of Independence

Part of the reason people become entrepreneurs is to forge their own paths. However, taking on VC investors means they will have a lot of input on how to run the company.

Summary

It can be a challenge to find enough funding to get your business off the ground. Venture capital could be the perfect solution if you have a promising business idea and high growth potential. 

Venture capital will often come from venture capital firms, financial institutions, or wealthy investors. But, it doesn’t always have to come in monetary form. It can also come in the form of technical or managerial expertise. 

Either way, venture capital typically gets allocated to a startup or small business with a promising future. It can be a good investment for an investor since there’s a chance they can receive an above-average and attractive return.