Table of Contents
- Introduction
- What is Venture Capital
- Types of Venture Capital
- Pre-seed
- Seed
- Early Stage
- The Process
- Pros of Venture Capital for Startups
- Cons of Venture Capital for Startups
Introduction
Every year, entrepreneurs create 50 million startups. But despite the millions of startup companies that exist in the world, only about 10% make it past their first year, and 90% of startups ultimately fail. One of the most common problems for startups? Cash flow.
As much as 82% of businesses that fail do so because of cash flow issues. Maybe they burn through funding too quickly, or they may fail to secure enough funding in the first place.
Venture capitalists know the risks of investing in businesses. But with the chance to help fund a unicorn—a private startup valued at over $1 billion—venture capitalists are more willing to take a chance on startups, even if they don’t have any other funding or assets in the early stages of the company.
What is Venture Capital?
Venture capital, sometimes abbreviated as VC, is a form of startup financing and a type of private equity that allows a startup business to offer a large share of their company to an investor or a few investors in exchange for funding or other benefits, like mentorship or talent.
Venture capital can come with high risks and high rewards for both investors and startups. Startups can secure funding through venture capital without needing to make monthly repayments, but they may need to give up some control over the creativity and management of the company. For investors, there’s a huge risk that the startup will fail, but there’s also an opportunity to make money if the startup takes off.
Types of Venture Capital
There are three main types of venture capital that a startup may pursue, depending on how new the business is. For instance, brand new startups that are still finalizing their ideas may pursue pre-seed funding, while businesses that are ready to start selling their product or service may seek out seed funding. Startups that have already had some success in their sales and are ready to expand production may try to secure early-stage funding.
Pre-Seed Funding
Brand new startups may seek VC through pre-seed funding. In this round of funding, a startup is beginning to form its business by creating a business plan and developing its first products or services to sell.
Although pre-seed funding typically involves a startup earning funding through bootstrapping or getting investments from family and friends, promising startups may gain attention from venture capitalists willing to take a risk on a disruptive idea.
Seed Funding
At the seed stage, a startup has a product or service that is ready to hit the market, but they need capital to start running the business until they make enough sales to turn a profit. This can be a great point for startups to seek out venture capital to fund the business without the stress of a repayment deadline, should sales not hit their goals.
Early-Stage Funding
Early-stage funding often involves rounds of funding that allow businesses to access more capital as they grow. Businesses that started selling a product or service and have had a lot of interest may seek out venture capital in early-stage funding to expand their operations and increase sales.
At this stage, a startup exhibits measurable growth, making it even more attractive for venture capitalists to invest.
The Process of Getting Venture Capital
The startup funding process for securing venture capital can be lengthy because venture capitalists are typically looking for a long-term partnership. They need time to thoroughly vet the startup and determine whether or not to invest. Securing VC funding typically takes about 3 to 9 months from initial contact to funding, although the time-frame will vary case by case. Then, it will be several years from when the firm or investor starts providing funding to when they exit.
Initial Contact and Meeting
Either the startup or the venture capital firm will initiate contact to express interest in funding. There are several ways a startup can reach out to a venture capital firm or investor, such as:
- Sending a cold email
- Connecting at an industry event
- Getting an introduction from someone in your network
After connecting, the parties will set up a meeting to discuss the startup and potential funding.
Share the Business Plan
If the venture capital firm is interested in the startup after the first meeting, they’ll want to see your pitch deck and business plan before you can move on to negotiating and signing a deal. The business plan should be thorough, spelling out the idea, the competition, the overall market, the target audience, how the business will operate, goals for the long-term, and how much funding the startup needs.
Due Diligence
The venture capital firm or investor will do due diligence by investigating the business. The firm or investor will need to thoroughly analyze the company, from its business plan to its management and operations.
The startup should also perform due diligence. Venture capitalists will often own up to half of the company’s equity, so the startup founder should review the VC firm or investor, such as reviewing the success of past investments.
Negotiation and Investment
Now that both parties have expressed interest and have gone through due diligence, they can begin negotiating the agreement terms. The negotiation will focus on how much funding the venture capitalist will invest and how much equity the startup will offer in exchange for the investor.
With the agreement signed, the venture capitalist will provide funding as outlined by the terms in the contract. This may involve providing all funding upfront, or the firm or investor may offer one amount upfront and additional funding as the company moves through series funding rounds. Typically, VC funding terms span 10 or more years, according to the U.S. Securities and Exchange Commission (SEC).
Management
Unlike a bank or lender, a venture capitalist will have some ownership through equity in the company. That means they may be more involved in the operations, even joining the startup’s board of directors or advisory team.
The venture capital firm or investor may help with technical operations, management, or hiring new employees. The venture capitalist can also connect startups to other investors, talent, or customers.
VC Exit
Eventually, the venture capitalist will enact its exit strategy, or way of leaving the company by selling their shares. Typically, a venture capitalist will exit when they feel they have hit the maximum profit possible, or they may exit a startup that is on the down-trend in order to minimize the amount of money they are losing in the investment.
There are multiple exit strategies a venture capitalist might take, including:
- Initial public offering (IPO): The startup goes public, selling shares of the company to the public on the stock market. This is a popular exit strategy that is on the rise. In fact, 2021 was a record year with 1,035 IPOs in the U.S.
- Secondary sale: A venture capitalist may exit by selling their shares to another venture capitalist.
- Mergers and acquisitions (M&A): A merger is when two companies join to form one company, and an acquisition is when one company buys another. In acquisitions and some mergers, one company may buy the majority of shares in the startup, allowing the venture capitalist to exit.
- Buybacks: A successful startup may earn enough revenue and build up enough cash to buy out shares from investors.
Pros of Venture Capital
Venture capital for startups can be an accessible way to gain more than just funding but also to grow your network and gain mentorship, too. Some benefits of venture capital for new and growing businesses include:
Secure Funding Without Repayments
If a startup founder doesn’t feel comfortable making repayments to a bank or other lender by a set deadline, venture capital can be a more accessible path to funding. Venture capital provides funding in exchange for equity, so the repayment is in the form of part ownership of the company.
If the startup does fail, the founder doesn’t have to stress about repaying an institution. The venture capital assumes risk when they offer the investment, and they will have an exit strategy in place to sell their shares.
Tap Into Talent
In addition to funding, venture capitalists may also provide access to mentorship or other expertise. For startup founders who may not have all the skills needed to manage a business, bringing in a venture capitalist can help fill those gaps.
Venture capitalists may also assist in hiring new employees and can even offer connections to talent as the business looks to expand its team.
No Funds or Assets Needed
Although having a growing business that’s already making sales can help make your startup a less risky investment to venture capitalists, there are firms and investors willing to take on startups that are brand new.
In order to maintain the most control over the company, a startup should seek out other funding options first, but that’s not a requirement. Venture capitalists can offer a large amount of funding, and a startup doesn’t have to have funds or assets before seeking VC.
Cons of Venture Capital
Venture capital has a lot of potential benefits for new businesses. However, venture capital for startups can also come with challenges for founders—from high competition, to get funding in the first place, to losing majority ownership, to venture capitalists over time.
Give Equity
If a startup founder secures a loan or grant to start their business, they don’t have to give up equity, or ownership, in the company. But if they secure funding via venture capital, the VC investor or firm will typically take between 20% and 50% equity, making them a significant owner in the business.
Share Control Over the Company
By exchanging large shares of equity for large amounts of funding from a venture capital investor or firm, a startup is also giving up some of its control over the company. Venture capitalists can help strengthen the business by helping out with operations, but they may also influence the future of the company in a way that the startup founder(s) doesn’t always agree with.
VC negotiations typically offer 20% to 50% equity in a startup, already a significant portion of ownership in the business. But a Crunchbase analysis found that by the time a venture capitalist exits, ownership hits a median of 53%. Some of the companies in the study had much higher VC ownership numbers, such as Etsy (62%), TrueCar (82%), and Sabre (97%).
Difficult to Access
In some ways, venture capital makes it easier for startups to access funding, even if the business is more of an idea than an established company making sales. But there’s still a lot of planning and work that needs to happen before securing venture capital, and there can be a lot of competition to get attention from a firm or investor. In 2022, 5,044,748 new businesses were formed in the U.S. That same year, there were about 1,000 active VC firms in the country.
Startups not only need to have a solid business plan that shows how they are prepared to operate in the long-term, but the business idea needs to be innovative and the startup should have strong potential for growth to stand out from the thousands of other businesses competing for investments.
Is Venture Capital for Startups Right for Your Business?
Venture capital is one of several methods of funding a startup. The exchange of funding for private equity can be a great fit for startups expecting rapid growth, and it’s also a beneficial path for startups who don’t want to be stuck with monthly repayments on a loan. But venture capital for startups comes with its risks, too, including giving up some creative control to another firm or investor. Startup founders will need to weigh the benefits and risks and do their own due diligence when considering whether VC funding is the right path to jumpstarting their business.
