Venture capital helps startups get funding. This term is often denoted by the VC abbreviation. Founders of a business give up a percentage of their ownership to a third party in exchange for growth perspectives. In this article, we’ll explain how a venture capital fund works and how entrepreneurs can attract this type of financial support.
Understanding venture capital firm structure
This is how companies within the venture capital industry make money:
- raise capital from limited partners,
- generate returns through venture projects in 10–12 years,
- repeat the cycle.
The term “limited partners” includes family offices, endowment funds, pension funds, and other institutional investors. They resort to VC to diversify their investments. A venture capital firm doesn’t leave all the revenue to itself but distributes it among its clients in proportion to their contribution.
This is a highly risky business. Limited partners entrust only a small part of their savings to VC. Few startups manage to take off and even fewer make their investors rich.
The principle “a small percentage of funds generates a large percentage of returns” is known as a power-law curve. If a VC fund fails to detect a startup that will generate a substantial income, it will need to close down. Limited partners will lose their money. This happens to most funds.
Roles in a VC fund
If you’re planning to work for a VC fund, you should know which job positions it features. This information should also come in handy for entrepreneurs who need to understand the structure of a company they’re planning to interact with.
Apart from the limited partners we’ve already mentioned, VC funds also rely on entrepreneurs in residence. It’s one of the venture capital remote jobs. These are private persons who work for the fund for around a year, analyzing prospective deals and helping sort out the most promising startups.
Venture capitalists, angel investors, and private equities
A venture capitalist is a representative of a fund backed up by limited partners. An angel investor acts independently as a private person, without partners. They support startups that seem promising to them with funds that 100% belong to them.
Venture capital is a special case of private equity. It embraces all equity and smaller investments that involve high risks and might bring high rewards.
Types of venture capital
Venture capital can be divided into three types:
- early stage,
- expansion,
- acquisition.
Early-stage capital enables the startup founders to qualify for other loans. It’s a small sum that usually includes seed financing and Series A funding. Entrepreneurs need this money to finalize the development of their products or services. Those who have already completed the development might need financial support to begin to function as a full-scale business.
Expansion lets startups open new branches or get a bridge loan to offer an IPO. First, they need to prove they are successful and sustainable with their first branch.
Acquisition is also known as buyout financing. Entrepreneurs might want to purchase someone else’s business or a part of it to be able to better develop their own.
Advantages and disadvantages of venture funding
Risks to consider when investing in venture capital
The table above showed the advantages and disadvantages of venture capital from the startup founder’s point of view. Now, let’s focus on the risks that investors and limited partners need to keep in mind.
- Illiquidity. If you offer financial support for a startup, you can’t expect it to start generating income this or next year. On average, a business needs 10 years to take off and start generating profit for its investors. Until then, it’s hard to predict whether the startup will succeed or not. Your investment will be long-term and illiquid.
- Transparency. Investment analysts can study the performance of public companies but not their private counterparts. If a startup is based on an innovative business concept, it would be impossible to compare it to rivals. VC investors might lack benchmarks to assess their risks and the potential profitability of their decisions.
- Expenses. Compared to traditional investments, VC involves higher fees. The average management fee of a venture capital firm is around 2% of assets under management. The “carry” (additional performance fees) might reach 20%.
Not everyone can join a VC fund unless they represent an institutional investor. Private individuals need to meet the qualification standards that each fund sets up individually. Your net worth might need to reach a certain threshold. You might need to have a portfolio of successful investments.
How to get funding by a venture capital firm
Getting funded by venture capital resembles a B2B sales funnel.
- Add potential investors to the top of the funnel
- Meet and nurture your investors
- Close the deal and onboard the investors
Some VC funds might be eager to support any type of startups. Others specialize in businesses with specific characteristics or from a specific industry (such as real estate technology or green energy). You can find a rating of VCs that suit your startup and contact them one by one.
It would be wise to check the official website of the fund you’re planning to contact and search for the list of businesses it has already supported.
Let’s use a real-life example. Does First Momentum Ventures ring a bell? Hundreds of aspiring entrepreneurs turn their eyes to this investment analyst venture. On its website, there are logos of businesses that it funded with the respective dates:
- Heyday — 2021
- One Five — 2021
- Pliant — 2020
- Rubarb — 2020
- Peers — 2019
- Consider.ly — 2018
- And many others.
Which characteristic traits do these startups share? Do they have anything in common with your business? If yes, it makes sense to try and contact First Momentum Ventures.
Once you’ve made a list of VCs that suit you, you should prepare the documents and metrics. Investors will be interested in your pitch deck, working capital, and cap table. All your verbal statements about your business should be backed up by facts and numbers. The information needs to be very well-structured.
When reaching out to potential investors, you can rely both on warm introductions and cold outreach. Quite often, the relationship between the investor and the startup would last around 10 years. When selecting an investor, you should make sure you understand each other well and share identical opinions on the key aspects of your business.
Once you’ve pitched to an investor, they might begin due diligence:
- audit your financials,
- survey your staff members and customers,
- study the market deeper.
Some venture capitalists might share checklists with you so that you know what to expect from due diligence.
Finally, the VC will offer you the term sheet. To get funding, you’ll need to accept their conditions.
Industries that VCs love the most
For every 20 investments a VC fund makes, only one will generate a large profit. Others will bring losses. VCs want to find a startup that will either be sold at a high price or go public. Technological companies have the highest potential in this aspect. Startups from other industries might grow and scale very well but fail to generate substantial returns.
However, if the team of a VC fund lacks expertise in technology, they’ll be more likely to support businesses from industries that they understand better. Besides, funds might want to diversify their investments and support businesses from various sectors and at various stages of development. That’s why a startup might get unexpected support from a not-so-obvious fund.
Which startups qualify for VC support
Four types of startups have the highest odds of getting money from VC funds.
Where to find VC investments
We’ve mentioned VC analysts who visit conferences to search for promising startups. Founders can behave proactively and look for VC support through these channels:
- Venture capital websites. You can google such websites, or ask fellow entrepreneurs for referrals, or check dedicated databases on Crunchbase and other similar resources.
- Incubators and accelerators. Most accelerators have pitch days where startups present to potential investors. You can take part in a pitch day if your business has a good idea and some traction but lacks funds.
- Events and networking. Hackathons, conferences, and competitions provide excellent opportunities for meeting investors. Don’t be shy and ask the contacts that you already have to introduce you to their acquaintances.
While looking for investors, you should make sure your startup keeps growing quickly. The speed of growth is the first factor that VCs will pay attention to when considering whether to support a business or not.
Questions to ask a potential VC investor
Before accepting an offer from a VC fund, a startup founder might want to have some questions answered.
- When was the last time the fund invested in a new company? If it was more than 6 months ago, the fund might have financial or organizational issues.
- How does the fund work with portfolio companies? Ask its representatives to put you in touch with other startup founders whom they supported. Gather feedback from these founders.
The terms of the deal between the VC and the startup should include information about the options pool for employees. Before signing the papers, it would be wise to discuss the pool in advance.
How much control a VC gets over a startup
In exchange for financial support, venture capitalists will ask for board involvement. They might want to become either board observers or board directors.
- The former is a no-fiduciary duty with no voting rights. During board meetings, observers tend to listen rather than speak. They can report back or add a new perspective to the conversation.
- Board members are usually previous investors or lead investors on the previous round of financing. They actively protect their investments, even though no additional equity is granted.
Most investors want board seats with veto rights. Compared to boards of companies where members don’t have large ownership stakes, boards of VC-backed startups are smaller and more involved in strategy formation.
Typically, a VC would buy in equity between 15% to 45% of a startup. At an early stage, the fund might strive to purchase a larger part of the company. But the founders need to stay motivated, they should realize it’s still their business. In the course of negotiations, the fund might agree to get a smaller share.
Alternatives to venture capital
If you fail to get funding from a VC fund, there are lots of other options to consider.
- Venture debt
- Monthly or annual recurring revenue lending
- Structured equity products
- Mezzanine financing
- Private equity
- Angel investors
- Loans from friends and family
- Crowdfunding
- SBA loans
Traditional banks might refuse a loan to a startup if it currently doesn’t generate profit.
Final thoughts
Hopefully, now you have a better understanding of how venture capital works and how you can benefit from it. Institutional and private investors entrust money to a VC fund. The fund selects the most promising startups and provides financial support to them. Startup owners give the investors a part of their businesses in exchange for funding. On average, it takes a startup around 10 years to begin bringing revenue to investors.
