- Access to capital is an important factor in whether startups succeed; a lack of capital may result in a business’s failure.
- Specialized firms invest in businesses they believe have strong potential for long-term growth.
- Business owners should carefully consider whether to seek venture capital, as it could result in a loss of business control.
- This article is for entrepreneurs who are launching high-growth businesses and are thinking about seeking funding from venture capital firms or angel investors.
Venture capital is a major source of funding for tech startups and other high-growth-potential companies that are in need of capital but may not be able to secure conventional financing, like a bank loan. However, not all businesses are well suited for this type of funding, and it comes with a cost to equity and, sometimes, a loss of company control.
So what is venture capital, and might it be right for your small business? This guide will explain everything you need to know about this form of funding, where it comes from, and who benefits from it.
What is venture capital?
Venture capital (VC) is money invested in startups or small businesses with high-growth potential. These investments often, but not always, come in a company’s early days, before the business has a finished product or meaningful revenue. Typically, the investments are made by established firms that specialize in finding the most promising young companies.
Why do businesses seek VC funding?
Entrepreneurs often turn to venture capitalists because banks and other traditional sources of financing are too risk averse to invest in small companies or pre-revenue startups. Many of the companies that successfully raise VC funding have developed rapidly scalable technologies, though an investment in any ambitious startup might be considered VC.
Unlike other forms of financing, where entrepreneurs are only required to pay back the loan amount plus interest, VC funding is usually provided in exchange for equity in the company. This ensures that, if the company succeeds, VC firms profit in accordance with the risk they took. In exchange for their money, VCs may also receive a board seat, giving them a say in the company’s future direction.
Where does venture capital come from?
Venture capital firms are the primary source of VC funding. These firms are usually composed of professional investors who understand the intricacies of financing and building new companies.
The money VC 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). According to the National Venture Capital Association, U.S. VC firms raised more than $100 billion and invested more than $300 billion in 2021.
Those who invest in venture capital funds are called 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, VCs expect a high return on their investment, typically delivered through a stake in the company. The relationship between the two parties can be lengthy. Instead of working to pay back the loan immediately, the VCs typically work with the company for five to 10 years before any money is repaid.
At the end of the investment, venture capitalists sell their shares in the company – often when the company is acquired or goes public – with the hope that they will receive significantly more than their initial investment.
Did you know?: Some of the most famous companies to have received venture capital during their startup periods are Apple, Microsoft and Google.
Venture capital vs. angel investors
Although both types of investors provide capital to startup companies, there are several key differences between VCs and angel investors. The biggest distinction is that VC comes from a firm or a business, while angel investments come from individuals.
A second key difference is that whereas VC firms often invest millions of dollars in a company, angel investors usually invest less than $1 million. In keeping with their smaller investment, angel investors generally have a less-hands-on role. At the other end of the investment spectrum, private equity investors invest more and take control of more established companies.
Tip: Make sure you and your VCs agree on what the money will pay for and what milestones it will enable the company to reach.
Examples of venture capital
Before approaching a venture capitalist, you must know which type of capital you require. Here are various types of capital funding:
This is the investment capital required to carry out market research and start forming a company before a business’s launch. It also includes the cost of creating a sample product and its administrative cost.
Startup and early-stage capital
This is the capital used to recruit key management, conduct additional research, and prepare a product or service for market. After launch, early-stage capital can help the business increase sales to reach the break-even point and increase efficiency.
Expansion and late-stage capital
This is funding used to expand your production to other products or sectors. It might also be used to increase market efforts for new products. As a company grows, capital goes into increasing the organization’s production capacity, ramping up marketing and boosting cash flow.
Bridge financing is capital that might be offered to help a company reach an important milestone, such as an initial public offering or a merger.
Pros and cons of venture capital for entrepreneurs
VC isn’t the only option for startups; there have never been more financing options for small businesses. Another route, for those who don’t want to give up control, is to bootstrap your business, which means to self-fund it. For those who do seek VC, there are both benefits and risks of this funding method.
Pros of venture capital funding
- Rapid business growth: VC aims to facilitate rapid growth, which can be very difficult without a significant capital infusion.
- Valuable guidance from experienced pros: Many VC firms are actively involved in running the companies in their portfolios. They assist in building strategies, connecting with potential partners and providing technical assistance. Venture capitalists often have huge networks that can provide a solid customer base for the company.
- No repayment obligations: If your startup fails, as the owner, you are not obligated to repay the VC funds invested in the company. However, you may lose control of your company and your initial investment in the company, plus the time and love you’ve invested over the years in your dream and your business.
Cons of venture capital funding
- Loss of control: A VC investment typically costs management at least some control over the company. When VCs have a majority stake, they may gain the final say in key management decisions, and they may be more interested in recouping their investment than in seeing you or your company succeed. Companies that are on the brink of success may want to think hard about taking outside money.
- Conflicts of interest: Some VC contracts state that the VC firm is not bound by noncompete agreements and other restrictions. That means the firm may invest in (or hold investments in) competing companies.
For the right startup, VC funding can supercharge growth
Under the right circumstances, VC can be a powerful accelerant for high-growth companies. However, entrepreneurs who pursue this route give up a portion of their profits and control. Whether to accept or pursue VC is one of the most important decisions a founder or leadership team will make. While this form of funding may not be right for every business, it could supercharge growth for the right company.