The Basics of Venture Capital Financing
If you’ve come up with a great business idea, but don’t have the money to bring it to market, it may feel like you’re left with few funding options. Banks aren’t interested in loaning to startups that have yet to make any money, and most people don’t have family or friends who are wealthy enough to provide the kind of cash needed to make a real go of it.
To this end, you may find yourself considering the venture capital market. While TV shows like Shark Tank have romanticized the world of venture capital, many entrepreneurs have little idea of how such financing actually works. Here we’ll walk you through the basics, so you’ll have a better understanding of whether or not this type of funding is right for your awesome new idea.
What is venture capital?
Venture capital (VC) is a form of business financing that comes from outside, private investors, who agree to fund a startup or small business in exchange for a high rate of return and some temporary control of how the company is run. The businesses that receive VC are generally considered to have exponentially high-growth potential, but are also often high risk.
VC is not about long-term investing. The investors are interested in providing the company with enough infrastructure and guidance for it to obtain significant size, profitability, and credibility, and then they want you to sell the business, so they can recoup their investment.
And VC also isn’t about investing just money—it can be offered in the form of management and/or technical expertise as well.
Once the business reaches a certain level of maturity—typically after 4 to 6 years—it’s usually sold to a corporation or made available for sale on the public equity market through an IPO. At this point, VC investors will liquidate their shares.
Simply put, VC investors buy a stake in your business idea, help nurture its growth for a short period, and then cash out their equity in your company when it reaches a certain point in its life cycle.
Who makes up venture capital investors?
Venture capital firms typically get the majority of their investment funds from major institutions—large corporations, financial firms, pension funds, university endowment funds, along with very wealthy private individuals, or “angel investors.” These institutions and individuals generally put only a small percentage of their overall funds into these high-risk investments, and they expect a high rate of return (between 20% and 35%) per year for the duration of their investment.
Usually, it won’t be just one VC firm financing a company. Instead, you’ll frequently find a group of two or three firms involved, with one serving as the “lead” investor and the others as “followers.” Outside of the small percentage of funds they invest, such co-investing offers further diversification, ensuring that even if one startup fails, they’ll be able to offset the loss with others that succeed.
Where do venture capitalists focus their investments?
Because they’re often hoping to take a chosen startup public, VC investors are looking for businesses with a potential for rapid growth, as opposed to small mom and pop shops. Given this, VC firms usually focus solely on high-growth market sectors.
Timing is also critical in VC. Investors tend to focus on industries that are in their adolescent stage of evolution. They avoid an industry’s earliest stages, when the technology and market are still unstable, as well as the later stages, when the market is saturated with competitors and its potential for growth has passed its peak. Today, for example, more than 25% of VC is focused on the Internet and its seemingly limitless technological applications.
Moreover, VC firms often specialize in certain areas: particular industry segments, stages of a company’s development, or specific geographical regions.
- Industry segments: cloud computing, mobile devices, healthcare, software, biotech, semiconductors, etc.
- Stages of a company: seed and startup stages, first and second stages, expansion stage, or pre-public stage.
- Geographic regions: Silicon Valley, New York, Chicago, South Florida, etc.
How can my company secure venture capital?
While VC firms look at numerous factors (which we’ll cover in a future article) when deciding whether or not to finance a specific company, you generally need to show investors that your business idea, company’s stage of development, and industry match their particular needs, values, and focus.
And most importantly, you’ll need to show them they can believe in you! You must prove that your experience, management acumen, and skills make you a relatively safe bet. Since they’re investing other people’s money, they want to feel confident that you’re worth the risk. By understanding how venture capital financing works and adjusting your expectations properly, you’ll have a jumpstart on the competition before you even give your first pitch.
Beyond these basics, there are a huge array of other legal and financial issues to consider when seeking venture capital. With us as your attorney, we can not only help you locate suitable VC investors, we can also walk you step-by-step through the complex process of preparing your business to qualify for funding.
This article is a service of Jayaraman Law, LLC. We offer a complete spectrum of legal services for businesses and can help you make the wisest choices on how to deal with your business throughout life and in the event of your death. We also offer a LIFT Start-Up Session™ or a LIFT Audit for an ongoing business, which includes a review of all the legal, financial, and tax systems you need for your business. Call us today at 312-722-6596 to schedule an appointment.