Venture Capital: Definition, What It Is & Who It’s Right For

Venture capital focuses on funding startups with high growth potential in exchange for equity in the company. It’s a good option for startups needing $100,000 to over $25 million in funding to scale. To apply, you must find the right venture capital firm, pitch your company, and pass its due diligence process.

What Is Venture Capital?

Venture Capital is a form of private equity for small, early-stage, and emerging startups with high growth potential needing capital to scale. Venture capital firms pool investor money to fund startups that are too risky for traditional financing, in exchange for equity. It also shapes the strategy of the company, provides expertise and makes introductions.

Startups that have already built its product and are starting to onboard customers can qualify for funding. Investors will want to see that the market is growing and that the founding team is capable of execution. Investors also need to see that they can scale the product or service to produce sufficient returns on their investment.

How Venture Capital Works

Venture capital is a type of equity financing provided by large institutional investors to growing startups in exchange for equity. Unlike startup business loans, there are no monthly payments and no outstanding debt for the startup. By forfeiting equity, founders lose some control, as investors want a say in the strategic decisions of the company.

Founders will need to find the right venture capital firm to partner with and raising venture capital can be challenging. They can present their company with a pitch deck, outlining their team, progress, and the opportunity they are seeking funding for. Typically, companies will want to have traction with customers and have the potential for high 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 is no minimum revenue or market share that is required. But you should be able to communicate to investors why your company can be 10 to one-hundred times as big in a few years and how you will get there.

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

How Venture Capital Is Repaid

How venture capital funding is repaid depends on the transaction structure. Venture capitalists use two primary investment methods: convertible debt or equity investments. Both investments are repaid when the company is sold or if the business goes public and starts selling stock. However, convertible debt can also be repaid in cash without impacting equity.

The two methods of funding venture capital firms use are:

Equity Venture Capital Investments

Equity investments by venture capital firms are settled with company equity. When a company is acquired or starts trading on a public exchange, venture capital firms are able to 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 $10 per share, the venture capital firm holding 100,000 shares will be paid $1 million as part of the acquisition.

Convertible Debt Venture Capital Investments

Convertible debt is repaid at a future funding or liquidity event. It’s 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 Role Venture Capitalists Take in Your Business

Typically, one or several of the partners of the venture capital firm will sit on the board of directors for your company. As members of your board, they will 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.

Rory Crawford, the founder of BevSpot, has successfully raised investments from Bain Capital Ventures and Accanto Partners. He describes the role venture capitalists play in your company as follows:

“It depends on the VC and on your style, but generally, they should be there to help with strategic conversations, high-level guidance, certain introductions, and to back you in later financing rounds as well. That’s the biggest component, will they be there for you when you need money again? If they won’t then it puts you in a very tough place.”

The exact details of who will sit on the board of directors are noted in the term sheet. Typically, three venture capitalists, three people you select, and one person for a tiebreaker that’s independent will sit on the board. 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.

What Venture Capital Funding Should Not Require

A venture capital investment should not require that it be made senior to other debt or any expensive interest payments. Although there will be restrictive covenants, beware of any covenants that are overly restrictive, especially related to the day-to-day management of the company. Your agreement should not make it such that the VC can force you into bankruptcy or impact the going concern of your business.

Some things venture capital funding should not require are:

1. Seniority to Other Types of 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 issue convertible debt, will have to make a choice of debt or equity financing, be wary of any deal that allows the investor to both capture the equity and be repaid the debt.

2. 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.

3. Expensive Interest Payments

Your venture capital funding should not require any interest payments at all. In rare circumstances, to retain more equity, part of the deal can be structured as debt financing. 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.

Who Venture Capital is Right For

Venture capital is best for startups that are growing quickly, have a well-rounded team in place, are in a growing market, and will forfeit equity. Startups have access to capital at different stages, including developing a minimal viable product, establishing customer traction, scaling for growth, and saturating demand before an IPO or acquisition. The timing and size of each investment depends on the market opportunity the startup is pursuing.

Some business stages that qualify for venture capital are:

• Startups with an idea and minimum viable product: You will need to have a proven idea and a working product to qualify for funding at this stake. Typically, here 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 that they 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, with over half raising at least $10 million.

Every industry imaginable has venture capital available to it, either through a specialized fund or through more broad funds. Just because you can qualify for venture capital funding, doesn’t mean it’s necessary for your business.

According to Dr. Brien Walton, Director of the Richard E. Dyke Center for Family Business and Assistant Professor of Entrepreneurship at Husson University:

“Entrepreneurs should consider venture capital as a resource of last resort, and with the specific purpose of facilitating hiring key staff, customer acquisition, or product development ― items that investors can track to determine how well the entrepreneur is using their investment.”

Giving up equity in your startup is not a light decision, and as Dr. Walton suggests should be considered as a last resort. Sometimes it’s the only source that can provide enough capital for a growing company or traditional lenders are unable or unwilling to take the risk. However, like any other source of capital, venture capitalists are interested in earning a timely return on their investment.

Dr. Brien Walton summarizes the return venture capital firms look for in the following way:

“Venture capital is not ‘patient’ capital that can wait decades for the company to slowly grow ― otherwise, it is difficult to compete against the relative safety of mutual funds or government bonds. Venture capital is looking for that diamond in the rough that can sustain double-digit growth year after year because the faster a company increases revenue and profits, the more valuable the company becomes.”

Most venture capital firms only agree to a few deals per year, and they expect to earn at least three times what they invested 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.

What it Takes to Qualify for Venture Capital Funding

Qualifying as a startup for venture capital investment requires that you show the potential for high growth, have a well-rounded management team and possess a business model that is scalable and profitable in the long run. You also must pass a due diligence process conducted by the venture capital firm before receiving any investments.

The stages for qualifying for venture capital funding include:

• 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 will 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 will 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.

Although this process can take a few months, even after you find the investors you will work with, there are things you can do to speed up the process. Rory Crawford, the founder of BevSpot, provided recommendations that can speed up the process and increase your chances of success:

“Build commitments and momentum before kicking off a formal process, create as much scarcity value and time pressure as possible, and move everybody forward at your pace. If you can do this, you can raise in a matter of weeks not months, but it’s very hard.”

This can be a dizzying and difficult process, especially for founders that are raising funds for the first time. Some ways 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 angel investors that were involved in funding your startup in the past.

How to Attract Venture Capital Investors

Venture capital investors scout conferences, university labs, and various industry data in search of new investments. This makes standing out in your industry and growing the best way to attract venture capitalists. Besides growth, they are also interested in your team, product, market, and your planned use of funds. The best ways to communicate these are by preparing and sharing a pitch deck.

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, outline exactly how much money you are looking to raise and how that money will be spent to facilitate growth.

Where to Find Venture Capital Funding

Finding venture capital firms is easy and you can often even apply online. However, it’s difficult to get noticed. You can build momentum by applying on venture capital websites, or by going through an incubator or accelerator to grab an investors’ attention. Regardless of the approach networking at events can often result in a warm introduction that will help your startup secure funding.

Some ways to find the right venture capital firm to fund your business are:

1. Venture Capital Websites

Applying for venture capital online is a lot like applying for work online. It produces mixed results unless you are an outstanding candidate and takes a long time. However, for many entrepreneurs, this is the best option. You can browse active venture capital firms in your industry with Crunchbase, or ask for a referral from other entrepreneurs.

The top five venture capital firms ranked by the number of investments are:

Largest Venture Capital Firms By Number of Investments

Source: Crunchbase Investor Profiles

2. Incubator & Accelerators

Incubators and accelerators specialize in preparing startups that have a good idea, some traction, and require additional capital. One way to find and apply to accelerators is through F6S. Most accelerators will have a pitch day, where the startups present to potential investors. In a lot of ways, admission and completion to one of these programs are like a stamp of approval for your company.

The top five accelerators ranked by the number of investments are:

Largest Accelerators By Number of Investments

Source: Crunchbase Investor Profiles

3. Events & Networking

Attending industry events, startup competitions, and hackathons is 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.

Dr. Brien Walton also notes when seeking capital:

“Founders often find it useful to approach financial advisers that work for investors ― think ‘executive search for investors’ ―
because that approach can lead to a warm introduction to likely investors and the adviser can be an ally.”

Although these are all great ways to attract capital, many time venture capital firms are out scouting for startups that are growing quickly. Losing focus on the company and growth to look for investment is often detrimental overall and can cause you to miss out on funding. Entrepreneurs should work to raise funding for their business and start sooner so that the process doesn’t result in a detriment to overall growth.

What Questions to Ask Potential Venture Capital Investors

Partners of venture capital firms will sit on the board of your company, have a direct influence over the strategic decisions, and play a large role in the company’s success. To find the best long-term match, ask about their past investments and what differentiates them from other companies. You should also inquire into the size and usefulness of their network and how much time they devote to their investments.

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 a company similar to yours. 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-prepared 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 typically make better long-term partners. Knowing they will 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 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 the guidance in scaling your company.

It’s important to evaluate your investors as the long-term business partners they will be. You will work with them for at least the next three years. These questions can put you on the right track from the start and make sure that your values and vision for the company are aligned.

Rory Crawford, the founder of BevSpot, recommends:

“Get to know them personally, this is somebody you are selling a piece of your company too. You don’t want to have investors that are not great people or people you want to do business with. Ask personal questions, get a sense for them and if there is a fit.”

Many partners at a venture capital firm will often sit on the boards of multiple companies. It’s important to understand how much of their time you will get, who they can introduce you to, and whether you can benefit from their active involvement. You will work with your investors as they take part in major decisions and offer advice as your business grows.

Advantages & Disadvantages of Venture Capital

There are several venture capital pros and cons to consider. Sometimes it’s the only way that a growing company can raise a large amount of capital, however, the founders’ equity is diluted. Your startup gets a better shot at success with access to additional resources, including cash flow freed up by a lack of interest payments, but getting the funding can be difficult.

Advantages of Venture Capital

Some advantages of raising venture capital to fund your startup are:

• A large amount of capital: With venture capital, startups raised a median of $6 million in 2018. This is much more than any other source of startup funding available.
• No interest payments: Without the burden of interest payments, your company has a much greater chance of success, because it can use cash flow to reinvest and create more growth.
• Additional guidance and resources: Venture capital firms refer to the capital it provides as smart money. This is because they provide not only funding but also take an active role in nurturing relationships, making introductions, offering guidance, and providing you with the expertise and resources to help you scale your business.

Disadvantages of Venture Capital

Some disadvantages of raising venture capital for your startup are:

• Dilutes your equity: Although early rounds of venture capital sometimes take the form of convertible debt, most investors will convert to equity if your startup is successful. Later rounds will usually exchange capital for equity in the company, which can reduce your ownership of the overall company.
• Reduces your control: When you lose the majority stake in your company, you will also lose a lot of control over its direction. When you raise a venture capital round, you will usually need to provide board seats to your investors, which gives your board ultimate control over broad strategic decisions at the company.
• Can be difficult to qualify: For most startups, venture capital is the last stage of funding before an acquisition or an IPO. It’s typically raised when the company is growing, in an expanding market, with a scalable product or service. Only 2,300 startups successfully raised venture capital for the first time in 2018.

Alternatives to Venture Capital Funding

Startups willing to give up equity, but not ready for venture capital investment can raise funds from angel investors. If your company is growing more slowly or you are unwilling to give up equity, an SBA startup loan is another alternative. Finally, at the early stages, you could access your retirement savings with a rollover for business startups and avoid both monthly payments and diluting your equity.

Some alternatives to venture capital for startup funding are:

Angel Investors

Angel investors provide a smaller round of financing to startups in the form of convertible debt. Many angel investors are former entrepreneurs and can provide access to their networks, advice, and some help to grow your startup. Like venture capital, there are no monthly payments leaving you more money to reinvest in your business.

However, angel investors are easier to pitch, especially if your startup is in the earlier stages of development, compared to venture capital. You’ll typically give up less equity in the process and keep more ownership and control. Although funding can take as long, angel investors expect to be repaid sooner than venture capitalists for their investment.

According to Tarek Alaruri, co-founder of Fairmarkit:

“Pitching angels is completely different from venture capitalists. They’re looking for a shorter time frame and would prefer a quick win with little dilution. Your financials and pitch should reflect this, include your exit options and how’d you sell the company quickly.”

SBA Startup Loans

Startup SBA loans include microloans up to $50,000 to small businesses that are having difficulty securing traditional financing. SBA microloans loans have monthly payments, but carry lower monthly payments and longer terms than its traditional counterparts. Unlike venture capital, there is no equity dilution, but there are monthly payments and the loan amounts are much smaller.

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. There are no monthly payments, similar to venture capital, but setting up a ROBS can be a complicated process with many rules needing to be followed to ensure compliance. The best ROBS providers regularly handle these deals and help startups get the funding they need.

Frequently Asked Questions (FAQs) About Venture Capital

What is a valuation cap?

A valuation cap appears on a safe agreement or term sheet when you raise money from venture capital firms or angel investors. This restricts the maximum value of the firm when debt is converted into equity. So, a $10 million valuation with a $5 million cap will convert investor debt to equity at the cap.

How do venture capitalists get paid?

Venture capitalists collect a salary, receive commissions for fundraising, and invest their own capital in the fund. When they raise funds from outside investors, they take part of the funds as a fee or commission for managing the money. By investing their own funds they can also receive a return on successful investments.

What nicknames do venture capital firms give their investments?

To quickly refer to companies and their performance, venture capitalists refer to them as unicorns, dragon eggs, and the walking dead. Each one represents the potential of the company, with unicorns exceeding $1 billion valuations, dragon eggs as high potential unknown companies, and the walking dead as companies that are no longer growing.

Bottom Line: What is Venture Capital & Who is it Right For?

Venture capital funding is reserved for startups with well-rounded teams, high growth, and scalable products. You can raise as much as several million dollars, in exchange for equity in the startup. 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 help, knowledge, and network that comes from experience scaling other startups.