If you’re in the business and startup game and are looking to go to the next level, you might have heard of venture capital.
Considering that the business world is highly competitive, it can take a while to see the fruits of your labour.
However, if you think your business has growth potential, then looking for financial opportunities to make it happen is a good idea.
In this article, we’ll talk about one way to finance your business: venture capital. We’ll talk about:
- What venture capital is and how it works
- The primary characteristics and stages of venture capital
- The pros and cons of financing through venture capital
- The difference between private equity and venture capital
- When and if you should consider venture capital for your business.
Let’s dive right in!
What is Venture Capital?
Venture capital is a type of financing that provides funds to startups and businesses that have high growth potential.
This financing usually comes from financial institutions, investors, or investment banks that are typically willing to take high-risk investments in return for potentially high returns.
As soon as the startup or small business has experienced growth, the investor will exit the company by listing on the stock exchange or selling to a trade buyer or through a management buyer.
Keep in mind that venture capital doesn’t always have to be money. For one, investments can be made in the form of technical or managerial expertise.
The Venture Capital Process: How Does It Work?
As with any financial process, the venture capital process is potentially confusing. How does it work exactly?
The process includes several stages — sourcing, due diligence, investment, and exit.
The first step for any business looking for finance is to submit a business plan. In the sourcing stage, venture capitalists identify potential investment opportunities.
In the due diligence stage, venture capitalists quickly evaluate the company’s financials, business model, products, and history. If a company passes the due diligence stage, then the venture capitalist will proceed and make an investment.
Finally, the exit stage involves selling the equity back to the company or other investors.
One example of the venture capital process is the investment in Facebook by Accel Partners in 2005.
At the time, Facebook was a small social networking site that was just getting started. Jim Breyer from Accel Partners recognized Facebook’s potential and invested 12.7 million USD in Facebook in exchange for a 10.7% stake in the company.
And today? Facebook is worth billions.
Key Characteristics of Venture Capital
Illiquidity of Investments
Venture capital investments are usually long-term investments, making them non-liquid. Illiquid investments are those that cannot be easily bought or sold and don’t offer the option for short-term payout.
Long-Term Investment Horizon
Venture capitalists have a long-term investment horizon, meaning they’re willing to wait several years for a return on their investment. Therefore, investments tend to offer high returns to compensate for the higher-than-normal risk.
In other words, the higher the investment horizon, the greater the risk. And when the risk is greater, so is the reward.
Large Discrepancy Between Private and Market Valuations
Since venture capital investments are held by private funds, there’s no way to determine the value of the investment.
Because of this, there’s often a large discrepancy between the valuation of a private company in the private market and its valuation in the public market.
Limited Information for Entrepreneurs
Another significant risk of venture capital investments is that there’s limited information for entrepreneurs. This can make it difficult for companies to determine if venture capital is good for their business or not.
Mismatch Between Entrepreneurs and VC Investors
Venture capitalists and entrepreneurs may have different goals and priorities regarding investment, and these differences can lead to a mismatch between them (or even conflict down the line).
The Stages of Venture Capital
Early Stage Finance
Early-stage finance is funding for companies in the development stage (also known as seed stage). The early stage of venture capital typically supports product development, marketing, commercial manufacturing, and sales.
Mid Stage Finance
Mid-stage financing involves providing funding to companies that have a proven business model and are looking to expand.
Later Stage Finance
Lastly, later-stage financing is when a company has gotten off the ground and started to grow its market share. This stage includes investing in companies that are looking to go public or be acquired by another company.
The Pros and Cons of Venture Capital
- Access to substantial funding that can lead to rapid growth (plus companies don't need cash flow or assets)
- Access to experienced investors who can provide leadership and guidance
- Potential for high returns on investment.
- Loss of control over the business due to investors demanding equity
- Pressure to grow quickly from investors thanks to expectations of rapid growth and results
- Potential conflicts with investors over the direction of the business.
Private Equity vs. Venture Capital
Due to their shared characteristics in making financial investments in businesses, private equity and venture capital are often confused with one another.
They both involve investors providing capital in return for a stake in a business, so what makes these two different?
Private equity involves investing in mature companies that are looking to expand or restructure. This is also often invested in a company that isn’t public and has developed profitable margins.
On the other hand, venture capital investors go for rapidly growing, early-stage companies with a proven revenue model.
As such, private equity investors and venture capital investors differ in the types of companies they finance, the amount of money they invest, and the percentage of company ownership that they claim.
When Should You Consider Venture Capital for Your Business?
The verdict: when should you consider venture capital for your business?
If you have growth potential, need substantial capital, and have the necessary time to grow, you might want to consider venture capital for your business.
Aside from that, you’ll also need a clear trajectory for growth to be able to get an investor. Additionally, only consider venture capital if you need a large sum of money for your business to reach the next level.
On the other hand, if you don’t have a clear path to profitability or are already generating significant revenue, then venture capital may not be the best option for you.
The Bottom Line
Hopefully, you now have a clear idea of what venture capital is, how it works, and whether your business needs it or not.
As we’ve discussed, venture capital can be a great way to take your startup business from the small leagues to the big ones – offering you a shot to become the next shining star of your industry.
However, before you jump on the venture capital bandwagon, you need to make sure it’s the right fit for your business. Only consider venture capital after speaking with investors and taking into careful consideration your business model, capital, and growth potential.
The opinions on this page are for general information purposes only and do not constitute legal advice on which you should rely.