How Venture Capital Works
Venture capital of something you hear about all the time. But, do you know what it is or how it works? Better yet, could you explain it to your friends at a party if asked? If not, we got you.
What Is Venture Capital?
Entrepreneurs need money for their startup companies. Venture capital is money that investors give to startups. Additionally, the money given by a venture capital firm usually comes from institutional investors, corporations or wealthy individuals looking to make a good return on investment.
Who Are Venture Capitalists?
A venture capitalist is someone who (usually as part of a more prominent venture capital firm) invests money in startup businesses. In return, the venture capitalist gets equity in the startup.
How Are Angel Investors Different From Venture Capitalists?
While both give money to startup companies, venture capitalists are typically professional investors who invest in a broad portfolio of new companies.
With this, they provide hands-on guidance and leverage their professional networks to help the new firm.
Alternatively, Angel investors tend to be wealthy individuals who like to invest in new companies, more or less as a hobby. Furthermore, they tend to invest first, with the VCs coming in later in the game.
Venture capital capitalists are NOT angel investors. Angel investors are individuals who invest their own money into companies.
Unlike your typical angel investor, venture capitalists are much less risk preferring. Since 7 out of 10 new ventures fail at a spectacular rate, they’re cautious about their risk.
Venture capitalists get involved considerably later in the game. Most are never at the seed stage. Furthermore, some don’t even get involved and the series A stage.
How Does A Venture Capital (VC) Fund Work?
- A VC fund consists of money from wealthy people or companies. These people give their money to the VC firm to manage and, in turn, invest it in high-risk startups in exchange for piece equity.
- Venture capitalists are in it for a short amount of time. Just enough to fund and exit while the iron is hot.
- The venture capital firm or investor will receive an equity partnership for the money invested in a startup company.
- VCs receive liquidation preference. If the company fails, VCs get the first claim to all the company’s assets and technology.
- Voting rights over critical decisions like Initial Public Offer (IPO) or even the sale of the company are given to the VC.
A Real-Life Example
It all starts with a vision, the project, the product, and the service. You have a hot, new, cutting edge product that, in your opinion, will change the world. Let’s say Alison and Chris are developing an app for monitoring blood sugar that’s getting a lot of patient and media attention.
With no competition, they see the potential in the company. But, they need money to pay the app developer, $500,000 to be exact. Sadly, however, the banks are hesitant to lend the money because, in their opinion, they think it’s too risky.
So, what options do Chris and Alison have? Do they quit? No. Instead, they source private funding (money from friends and family) or venture capital.
A successful venture capitalist, Ryan looks at what Alison and Chris have done and thinks the benefits outweigh the risks. He learns about the product and reads the business plan. Ryan likes what he sees it decides to invest $1M in Alison and Chris’ company.
He does the same and amounts to other startups with similar potential. In return for his investment, he gets a piece of the company in equity.
The Steps In Raising Money
If you want to get into the venture capital world, then you need to master the steps to do so.
Types of Funding: As for how much money Alison and Chris get, that depends on where their company is at. The first money into the company is the founder’s money, money that Alison and Chris contributed. Then there’s the seed money, something to get the party started.
Seed Funding: Seed funding is the earliest stage, basically something to get the party going. Maybe it’s only $10,000, maybe it $100,000. As I mentioned above, the first money into a company is the founder’s money and friends and family money.
The company doesn’t have revenue yet at the seed stage, but it’s starting to get traction. However, it’s still a risky stage as 7 out of 10 startups fail. Check out our Seedinvest review as this is something they offer.
Getting An Equity Stake
Friends and family and venture capitalists aren’t going to give you their money unless you provide them with a piece of the pie. So your newly incorporated company issues 100,000 shares of equal parts of ownership. But, of course, as a founder, you need to decide how many shares each investor gets along with yourself.
Without a doubt, there are going to be some tough questions. For example, does each founder get 40% of the company or 40,000 shares? Do the remaining 20,000 shares go to a family friend who invested $50,000 early on?
Let’s say you’re a year in. Or, as the finance world calls it, you’ve got one year of beta testing under your belt. Without additional capital, growth will stagnate; thus, you are now ready for series A funding.
Venture Capital Funding Series A
Series A is for when the company has established product and market fit start it to make some serious buzz, and its customer base is growing fast.
Next, you need to hire a few more people, rent office space and pay for the server to host your app.
The $10,000 in seed capital only got you so far; now it’s time to collect your first big round of cash.
To collect more money, you do a so-called series A round. At this point, You’re looking for an investment of $1 million. This time you’re contacting angel investors and venture capitalists.
Series B Venture Capital Funding
Series B funding occurs when the company has started to make considerable revenue. At this point, they’re looking to expand operations. Funding can range from $ 7 million – $ 20 million, which can go towards business development and advertising.
Series C Funding
Series C and onwards is when the company has grown up and is likely operating globally. Funding received is usually in the range of $25 million and is used to develop more products and services and acquire another company.
The company may be ready for an IPO, bought out by another company or continue operating as a private firm.
So let’s say Alison and Chris have stayed in the game, gone through Series C and now want to cash out.
Enter the IPO or Initial Public Offering Stage.
Alison and Chris decide to IPO, making their company public on the stock market. If all goes well, Ryan will make an excellent return on his initial investment.
The Venture Capital Game
Venture capital firms are NOT in the business of taking risks. Venture capitalists are in the business of mitigating their risk relative to the reward. So what does that mean? that means every venture capitalist is very cautious about the type of risk they take on.