Venture Capital: What It Is & How It Works

Venture capital is a type of private equity for emerging startups that have high growth potential and need capital to scale their business. Venture capital firms pool investor money to fund startups in exchange for equity and also shape the strategies of the companies, provide expertise, and make introductions. It’s a good option for startups needing between $100,000 and $25 million in funding. To apply, you must find the right venture capital firm, pitch your company, and pass the firm’s due diligence process.

How Venture Capital Works

Unlike startup business loans, there’s no monthly payment and no outstanding debt for the startup with venture capital. By forfeiting equity, business owners lose some control since investors want a say in the strategic decisions of the company. Founders will need to find the right venture capital firm to partner with. They can present their company with a pitch deck, outlining their team, progress, and the opportunity they’re seeking funding for. Typically, companies will want to have traction with customers and have the potential for significant growth.

The potential for high growth varies by industry. However, your startup should be in a growing market, have a product that customers love, and be scalable. There’s no minimum revenue or market share required. However, you need to communicate to investors why your company can be 10 or even 100 times larger in a few years and how that will happen.

Once you receive funding, investors help your company by providing advice and introductions. To mitigate some risks and promote the success of their investments, many venture capital partners will require a presence on a company’s board of directors. This puts them in a position to review and approve major decisions at the company. This also means you will have a reduced amount of control over the company.

Who Venture Capital Is Right For

Some business stages that qualify startups for venture capital are:

Startups with an idea and minimum viable product: You’ll need to have a proven idea and a working product to qualify for funding at this stake. Typically, at this point, a startup has already shown that its customers need the product in a growing market.
Startups with established customer traction: Customer traction goes beyond a minimum viable product. The key difference is that the number of customers is growing and they’re willing to pay. Funding at this stage helps startups invest in marketing, meet customer demand, and expand their reach.
Startups with high growth and scalability: Once a startup has established that customers are interested and willing to pay, they often gain early adopters. After these early adopters, growth speeds up as the company saturates a niche. Here, venture capital funding helps companies scale their infrastructure and processes to maintain growth.
Startups preparing for an initial public offering (IPO) or acquisition: Once the processes are established, companies grow to saturate market demand. In especially large markets, there can be several rounds of funding to get through this stage. Typically, these are larger rounds that can reach over $10 million.

Many industries have venture capital available to them, either through a specialized fund or through more broad funds. But just because you can qualify for venture capital funding doesn’t mean it’s necessary or the best choice for your business. However, it may end up as the only source that can provide enough capital for a growing company, especially if traditional lenders are unable or unwilling to take the risk.

Giving up equity in your startup isn’t a decision to make lightly. However, like any other source of capital, venture capitalists are interested in earning a timely return on their investment.

How to Qualify for Venture Capital Funding

Qualifying as a startup for venture capital investment requires the following:

Finding and pitching potential venture capital investors: Venture capitalists browse pitch decks, competitions, and various publications to discover startups. If they invite your startup to pitch, you’ll need to present your company and opportunity. If accepted, investors will conduct due diligence to determine if your company is eligible.
Passing the due diligence process: The initial due diligence takes two weeks and examines product and company viability. After this stage, you’ll receive an offer and start final due diligence. This entails background checks of founders and a thorough audit of the company. It can take several months, depending on the complexity of your business.
Accepting an offer and receiving funding: When your startup makes it past this stage, you can accept the offer. Usually, you won’t receive all the money, as most of it’ll be unlocked once the company reaches certain performance goals and targets. The deal isn’t certain until investors have transferred the money to the startup.

A pitch deck for venture capitalists should contain information about your business and your team. It should highlight your most recent financial performance and provide guidance for future development along with a road map on how the company will get there. Finally, it should outline exactly how much money you’re looking to raise and how that money will be spent to facilitate growth.

The process can typically take a few months and can be both dizzying and difficult, especially for founders that are raising funds for the first time. One way to lessen the burden for founders is to work with professionals like accountants and lawyers that are experienced with venture capital. You can also receive help from any angel investors that were involved in funding your startup in the past.

Venture capital firms typically agree to just a few deals each year, and they expect to earn at least three times their investment over the next five to seven years. These earnings include companies that don’t make it, meaning successful projects often earn 20 times the original investment. When attempting to raise venture capital, investors will scrutinize your startup through this lens to determine if you qualify.

The Role Venture Capitalists Take in Your Business

Typically, one or more partners of the venture capital firm will sit on your company’s board of directors. As members of your board, they’ll have the authority to remove you from your position as an executive at the company, veto any major decisions regarding company directions, and will oversee the overall strategy of your startup.

The exact details of who’ll sit on the board of directors are noted in the term sheet. One potential example of how a board of directors could look is this: three venture capitalists, three people you select, and one person (for a tiebreaker) that’s independent. Many founders don’t realize how much authority the board of directors has over them and are surprised to find that even though they keep much of the equity, they have little power.

How Venture Capital Is Repaid

The way venture capital funding is repaid depends on the transaction structure. The two primary structures that venture capital firms use are:

Equity

Equity venture capital investments are settled with company equity. When a company is acquired or starts trading on a public exchange, venture capital firms can liquidate some of their holdings in the company to realize a profit. There are no payments made by the entrepreneur for this type of funding.

As an example, a startup that raised $200,000 in exchange for 100,000 shares received a share price of $2 per share. When that same company is acquired at a new price of $20 per share, the venture capital firm holding 100,000 shares will be paid $2 million as part of the acquisition.

Convertible Debt

Any venture capital investments through convertible debt are repaid at a future funding or liquidity event. These payments are issued with a premium, typically 20%, and the investor has the option to receive payment in the form of cash or equity in the company. A liquidity event takes the form of an acquisition, subsequent fundraising round, or an IPO.

For example, your startup receives $100,000 with a 20% premium in convertible debt from investor A. After several years of growth, the company raises $200,000 from another venture capital firm, investor B, for 10% of its equity. This gives the company a valuation of $2 million. Investor A can now receive $120,000 in cash as payment or the equivalent value in equity.

What Venture Capital Funding Should Not Require

Seniority to other debt: Although venture capital investment is considered high risk, it shouldn’t be senior to other types of debt like personal loans for business funding. This allows you to continue to borrow funds if needed from other sources. Additionally, most investors that issue convertible debt will have to make a choice of debt or equity. Be wary of any deal that allows the investor to both capture the equity and have their debt repaid.
Overly restrictive covenants: Most venture capital funding comes with restrictive covenants to ensure that investor money is used prudently. These include requirements for investor approval in the case of selling the company, issuing securities, changing board structure, incurring debt, and paying dividends. Any further restrictions on actions that fall under the umbrella of day-to-day management can be considered overly restrictive and shouldn’t be required for venture capital funding.
Interest payments: Your venture capital funding shouldn’t require any interest payments. In rare circumstances, to retain more equity, part of the deal can be structured as debt. Typically, this is done for mature startups close to a buyout that can’t afford additional equity dilution. If this is the case, the interest payments should be small and easy to cover with existing cash flow.

Where to Find Venture Capital Funding

While finding venture capital firms is easy, as you can often even apply online, it’s difficult to get noticed. Here are some options to help you in your search for venture capital:

Venture capital websites: For many entrepreneurs, using a venture capital website is a great option, as it allows you to search out venture capital firms that have an interest in your industry. You can browse active venture capital firms in your industry with Crunchbase, or ask for a referral from other entrepreneurs.
Incubators and accelerators: Both of these specialize in preparing startups that have a good idea, some traction, and require additional capital. One way to apply to accelerators is through F6S. Most accelerators will have a pitch day where startups present to potential investors. Admission to and completion of one of these programs can be seen as a stamp of approval for your company.
Events and networking: Industry events, startup competitions, and hackathons are always a good way to meet people, and more often than not, potential investors from venture capital firms will be there too. You can often leverage other founders, angel investors, and university professors for an introduction to venture capitalists also.

Don’t Lose Focus: Venture capital investors look for startups that are growing quickly. Losing focus on the growth of the company to primarily look for investment can be detrimental. Entrepreneurs should work strategically and thoughtfully in the pursuit of venture capital for their businesses.

Questions to Ask Potential Venture Capital Investors

Potential venture capital partners need to be a strategic fit for you and your company.

It’s important to consider potential investors as long-term business partners, given you’ll work with them for at least the next three years. Some questions you can ask potential venture capital investors are:

What other companies have you invested in?

This will help you gauge the relative success of past investments and whether the venture capital firm has experience with companies in your industry. You can also use this information to reach out to other founders and see what their experiences with the venture capital firm have been.

Who are you able to introduce us to in your network?

Drawing on the existing networks of a venture capitalist is one of the largest advantages of raising venture capital over other forms of financing. However, you’ll want to make sure that their network includes people that are beneficial for your startup. A well-connected venture capitalist should be able to suggest at least a handful of contacts and be able to explain how these people will help your startup.

Do you take part in subsequent rounds of funding?

Although this question isn’t the most important in the short run, it can help you decide between two similar offers from venture capital firms. A venture capital firm that has a track record for taking part in future rounds of funding with their startups is typically a better long-term partner. Knowing they’ll invest again later can also reduce anxiety around fundraising for founders.

What differentiates you from other venture capital firms?

Every venture capital firm refers to its investment as “smart” money. This means that, besides capital, they provide advice, introductions, guidance, and other benefits to the startups they invest in. Understanding what those benefits are and how your startup can take advantage of them paves the way for greater success.

How many other companies do you devote your time to?

This question will help you understand how busy your investors are. If they have too many commitments, they may not devote the necessary time to your company. This is important if you expect to rely on venture capitalists for guidance in scaling your company.

Advantages and Disadvantages of Venture Capital

There are several advantages and disadvantages to venture capital. The top three are:


PROS	CONS
Access to a large amount of capital	Dilutes your equity
No interest payments	Reduces your control in business
Additional guidance and connection to resources	Can be difficult to qualify

Alternatives to Venture Capital Funding

Startups willing to give up equity but not ready for venture capital investment can raise or borrow funds from several different sources. Some alternatives to venture capital for startup funding are:

Angel investors: Angel investors provide smaller rounds of financing to startups in the form of convertible debt. Many angel investors are former entrepreneurs who can provide access to their networks, advice, and help with growing your startup. Like venture capital, there are no monthly payments, which leaves you more money to reinvest in your business. Angel investors are also more receptive to pitches from businesses; however, they expect faster repayment for their investment.
Small business loans: Small business loans come in various forms and can be obtained through either a traditional bank or through an online lender. There are even lenders that will lend based on your online marketplace receivables. SBA loans are government-backed and come with long terms and low rates, while online lenders have relatively lenient qualification requirements and simple application processes.
Rollover for Business Startups (ROBS): A ROBS allows you to access retirement funds in a 401(k) or IRA account without the typical taxes and fees associated with early withdrawal. Similar to venture capital, there are no monthly payments, but setting up a ROBS can be a complicated process, and many rules need to be followed to ensure compliance. High-quality ROBS providers regularly handle these deals and help startups get the funding they need.

Bottom Line

Venture capital funding is reserved for startups that have well-rounded teams and the potential for high growth and scalability. You can potentially raise several million dollars in exchange for equity in your business. Venture capital firms will have partners sit on your board (which can reduce your decision-making freedom within the company) but also provide you with the guidance and support that comes from their experience with scaling other startups.