Venture Capital: What It Is & How It Works

Venture capital is a type of private equity designed to help startups with long-term growth potential scale. In this type of arrangement, groups of investors pool money to fund a startup in exchange for equity. Typically, venture capitalist firms also shape the strategies of the companies, provide expertise, and make introductions.

Firms usually offer anywhere from $100,000 to $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

Venture capital is a partnership between a growing startup and its investors. Unlike financing from business loans, venture capital does not require collateral or monthly payments. Instead, you forfeit some level of ownership stake, thereby giving your investors a say in the strategic decisions of the company.

Many venture capital partners will want a place on your company’s board of directors. However, because they are interested in the success of their investments, they help your company by providing advice and introductions.

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 are seeking funding for. Typically, venture capital firms only fund startups with significant growth potential. This means that your startup should be in a growing market, have traction with customers, and be scalable.

There is 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 you can make that happen.

Advantages and Disadvantages of Venture Capital

There are several pros and cons to venture capital. The top three are:

Who Venture Capital is Right For

Here are a few examples of businesses that attract venture capital investors:

• Startups with an idea and minimum viable product: Investors are willing to provide capital for businesses with proven ideas and working products. Typically, at this point, a startup has already demonstrated that customers need the product in a growing market.
• Startups with established customer traction: Customer traction goes beyond a minimum viable product. Having a growing client base proves that your product can sell, foster loyalty, and attract more people who are 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.

The Role Venture Capitalists Play in Your Business

Typically, at least one member of your partner firm will sit on your company’s board of directors, overseeing the overall strategy of your startup. Their position gives them the authority to veto any major decisions regarding company directions. They even have the power to remove you as an executive of your company.

The exact details of who will sit on the board of directors are noted in the term sheet. Here is a potential example of how a board of directors could look:

• Three venture capitalists
• Three people you’ve selected
• One person not from either side, acting as a tiebreaker

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.

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: Online investor databases provide detailed lists of active venture capital investors. These databases typically include information about each investor’s location, the industries they prefer to invest in, and how much capital they typically provide. You can browse active venture capital firms in your industry by visiting Crunchbase, a provider of company insights, or asking for a referral from other entrepreneurs.
• Incubators and accelerators: Startup incubators and accelerators are programs designed to help early-stage businesses get resources. Both specialize in preparing startups that have a good idea and some traction, as well as require additional capital. Most accelerators will have a pitch day where startups present to potential investors. Additionally, admission to and completion of one of these programs can be seen as a stamp of approval for your company. One way to apply to accelerators is through F6S, a platform that lets founders interact with investors, accelerators, and incubators, and more. Head over to F6S.
• Events and networking: Industry events, startup competitions, and hackathons are always a good way to meet people. 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.

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 will work with them for at least the next three years. Some questions you can ask potential venture capital investors are:

1. What other companies have you invested in? This question helps you gauge the relative success of your partner’s past investments. It also tells you whether they have experience with companies in your industry. You can use this information to reach out to the other startups your partners have funded and ask about their experience with the firm.
2. Who can you introduce us to in your network? Gaining connections through your venture capital partner’s existing networks is one of the largest advantages of raising venture capital over other forms of financing. You’ll want to ensure that their network includes people who can help your startup. A well-connected venture capitalist should be able to suggest at least a handful of contacts and explain how these people can provide assistance.
3. 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 typically is a better long-term partner. Knowing they will invest again later can also reduce anxiety around fundraising for founders.
4. 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.
5. 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.

How To Get Venture Capital Funding

To get funding, complete the following steps.

Step 1: Pitch Potential Venture to Capital Investors

Interested investors typically will call you to present your company through a pitch deck. Venture capital pitch decks 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 are looking to raise and how you will allocate these funds to facilitate growth.

Step 2: Pass the Due Diligence Process

If your pitch gains investor approval, your partners will put your company through a due diligence process to determine whether it is eligible for funding. First, they will examine your product and company viability. This part of the process typically takes two weeks.

Once you pass the first stage, you’ll receive an offer and start the final due diligence process. 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.

The initial due diligence takes two weeks and examines product and company viability. After this stage, you’ll receive an offer and start the 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.

Step 3: Accept an Offer & Receive Funding

If your startup passes the due diligence process, you can accept an offer. However, your partner won’t transfer all the money at once. Venture capitalists typically set performance goals, dispensing funds only when you meet certain milestones, such as revenue and customer acquisition.

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.

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 and convertible debt.

1. Equity

Equity venture capital investments are settled with company equity. When a company is acquired or starts trading its shares on a public exchange, venture capital firms can liquidate some of their holdings in the company for a profit.

As an example, a startup that raised $200,000 in exchange for 100,000 company shares received an initial share price of $2 per share. When a new company acquires the startup at a price of $20 per share, it pays the venture capital firm $2 million to buy off its 100,000 shares during the acquisition.

2. Convertible Debt

Any venture capital investments through convertible debt are repaid at a future funding or liquidity event. You issue these payments at a premium (typically 20%), and your investor has the option to receive payment in the form of cash or equity in the company. Liquidity events refer to acquisitions, subsequent fundraising rounds, or IPOs.

For instance, 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

Here are red flags to watch out for when making venture capital deals:

• Seniority to other debt: Although venture capital investment is considered high risk, it should not 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 have issued 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 should not be required for venture capital funding.
• Interest payments: Your venture capital funding should not 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.

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. Here are a few venture capital alternatives.

1. 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, angel investors do not require 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.

2. Small Business Loans

Business lending products typically are the most accessible funding methods available. Although many businesses require companies to meet certain requirements, their availability in banks and other financial institutions makes them easier to obtain than angel investments and venture capital, which require a little more networking.

Lending products typically require monthly payments or collateral. However, you don’t need to forfeit equity, which gives you more control over major business decisions.

Check out our article on startup business loans for more examples of lending products that fit startup needs. Two options to consider are the following:

• Small Business Administration (SBA) loans: SBA loans are government-backed and come with long terms and low rates. Online SBA lenders have relatively lenient qualification requirements and simple application processes. Read our guide on the types of SBA loans for more information.
• Revenue-based financing: This form of financing lets you borrow against future revenue. You pay off the debt with a fixed percentage of your monthly revenue. Because the payment amount is percentage-based, you don’t have to worry about not meeting minimums during slow revenue months. For a more detailed explanation, refer to our article on how revenue-based loans work.

3. Rollover for Business Startups (ROBS)

A ROBS lets you fund your business through retirement funds in a 401(k) or individual retirement account (IRA) account. However, this system comes without the typical taxes and fees associated with early withdrawal.

Similar to venture capital, a ROBS requires zero monthly payments. However, 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. Our list of the best ROBS providers can help you find options.

For additional recommendations, check out our list of alternative startup funding options.

Bottom Line

If your organization has a high potential for growth and scalability, then gaining funding through venture capital would be a great option. You can potentially raise several million dollars in exchange for equity in your business. Although venture capital firms will reduce your decision-making freedom within the company, they also provide guidance and support.