- Access to capital is a critical factor for business startups to succeed. Lack of enough capital may result in failure.
- Venture capital is offered by high net-worth individuals to small businesses that they believe have a strong potential for long-term growth.
- Business owners should make decisions carefully before taking up venture capital as it could result in a loss of business control.
Among the various financing options entrepreneurs can turn to when starting a new company is venture capital. Venture capital is money that is given to help build new startups that have a strong potential for growth. Many venture capital firms invest in companies in the healthcare field or that have developed a new technology, such as software. A new breed of venture capital firms has formed to focus on investing in socially responsible companies.
Entrepreneurs often turn to venture capitalists for money because their company is so new, unproven and risky that more traditional forms of financing, such as through banks, aren't readily available. Unlike other forms of financing where entrepreneurs are only required to pay back the loan amount plus interest, venture capital investments commonly require a portion of ownership in exchange for funding. This is to ensure they have a say in the future direction of the company.
Not all venture capital investments take place when a company is first being founded. Venture capitalists can provide funding throughout the various stages of a company's progression. Research from the National Venture Capital Association revealed that in 2010, venture capitalists invested approximately $22 billion into nearly 2,749 companies, including 1,000 of which received funding for the first time. Among the more famous companies to receive venture capital during their startup periods are Apple, Compaq, Microsoft and Google.
Where does venture capital come from?
Venture capital funds come from venture capital firms, which comprise professional investors who understand the intricacies of financing and building newly formed companies. The money that venture capital firms invest comes from a variety of sources, including private and public pension funds, endowment funds, foundations, corporations and wealthy individuals, both domestic and foreign.
Those who invest money in venture capital funds are considered limited partners, while the venture capitalists are the general partners charged with managing the fund and working with the individual companies. The general partners take a very active role in working with the company's founders and executives to ensure the company is growing profitably.
In exchange for their funding, venture capitalists expect a high return on their investment as well as shares of the company. This means the relationship between the two parties can be lengthy. Instead of working to pay back the loan immediately, the venture capitalists work with the company five to 10 years before any money is repaid.
At the end of the investment, venture capitalists sell their shares in the company back to the owners, or through an initial public offering, with the hope that they will receive significantly more than their initial investment.
Venture capital vs. angel investors
While both types of investors provide capital to startup companies, there are several key differences between venture capitalists and angel investors. The biggest distinction is that venture capital comes from a firm or a business, while angel investments come from individuals. A second key difference is that while new startups typically receive millions of dollars in venture capital, angel investors typically never invest more than $1 million into a project.
A third difference is that venture capitalists generally invest in a startup they feel has the potential to generate significant profits, while angel investors generally prefer to invest in firms that work in industries the angel investor is personally familiar with. Fourth, angel investors don't always require that they have a hands-on role in the running of the company, whereas venture capitalists do.
Examples of venture capital
Before approaching a venture capitalist, it is crucial that you are well aware of the type of capital that you require. Here are various types of capital funding.
This is the investment capital required to carry out market research required before setting up a business. It also includes the cost of creating a sample product and its administrative cost. Few venture capitalists are willing to invest in this stage.
These are the capital requirements to fund the recruitment of key management, additional research, finalizing of the product and service for introduction into the market.
This is capital offered to increase sales to the break-even point and increase business efficiency.
This the funding required to expand your production to other products or sectors. Funding is used to increase market efforts for new products.
Capital is invested in increasing the organization's production capacity, to ramp up marketing and increase working capital.
Bridge financing is offered to facilitate mergers and acquisitions or to attract public financing through issuing of shares.
The pros and cons of venture capital for entrepreneurs
As a startup or the owner of a small business, while you may not qualify for financing from traditional lenders or credit unions, you have a few different options. One option is that you might qualify for some types of financing; another option if you don't want to have to relinquish a majority – or controlling – interest in your business is to bootstrap.
If you do pursue venture capital, or if you're approached by an investor, there are some benefits to these types of financial arrangements as well as some issues to be wary of.
Venture capital can provide an opportunity for business growth. Struggling companies are given the required financial muscle to achieve their goals. However, for the capital infusion that your business gets, many venture capital firms require an ownership stake of more than 50% in your company, which means you no longer have the final say in fundamental management decisions.
Valuable guidance and expertise
Venture capital firms are actively involved in the running of the business, providing their expertise and guidance in the decision-making process. They assist in building strategies, resources and provide technical assistance. Venture capitalists often have huge network connections, which can provide a solid customer base for the company.
On the other hand, your company may be on the brink of success without the use of investor funds. With a few adjustments to your business model, you may be able to increase profitability without needing to hire expensive staff or bring in management experts who do not understand your business, your products or services and who will not be with your business for the long haul.
Some venture capital contracts state in the terms that the venture capital firm is not bound by certain noncompete restrictions, which means the firm may invest in (or hold investments in) competing companies.
No obligation for repayment
If your startup fails, as the owner, you are not obligated to repay the funds. You do, however, lose control of your company as well as your initial investment in the company, plus the time and love you've invested over the years in your dream and your business.
If you're at a point in your startup or business where additional funding will make or break your company, carefully consider your end goal, the options available to you and what is ultimately best for you and your business.