April 5th, 2019 | By: The Startups Team | Tags: VC
Venture capital is financing that’s invested in startups and small businesses that are usually high risk, but also have the potential for exponential growth.
The goal of a venture capital investment is a very high return for the venture capital firm, usually in the form of an acquisition of the startup or an IPO.
A venture capital firm is usually run by a handful of partners who have raised a large sum of money from a group of limited partners (LPs) to invest on their behalf. The LPs are typically large institutions, like a State Teachers Retirement System or a university who are using the services of the VC to help generate big returns on their money.
The partners then have a window of 7-10 years with which to make those investments, and more importantly, generate a big return.
Creating a big return in such a short span of time means that VCs must invest in deals that have a giant outcome.
These big outcomes not only provide great returns to the fund, they also help cover the losses of the high number of failures that high risk investing attracts.
Although VCs have large sums of money, they typically invest that capital in a relatively small number of deals. It’s not uncommon for a VC with $100 million of capital to manage less than 30 investments in the entire lifetime of their fund.
The reason for this is that once each investment is made, the partners must personally manage that investment for up to 10 years. While money is often plentiful, the VC’s time is very limited.
With such a small number of investments to make, VCs tend to be very selective in the type of deals they do, typically placing just a few bets each year.
Regardless, they still may see thousands of entrepreneurs in a given year, making the probability that an entrepreneur will be the lucky recipient of a big check pretty small.
The most common check written by a venture capital firm is around $5 million and is considered a “Series A” investment. Early stage startups rarely secure Series A capital as an initial investment. Most begin with raising money from friends and family, then angel investors, and then a venture capital firm.
Depending on the size of the firm, VCs will write checks as little as $250,000 and as much as $100 million. The smaller checks are typically the domain of angel investors, so VCs will only go into smaller sums when they feel there is a compelling reason to get in early at a startup company.
Venture capitalists also tend to migrate toward certain industries or trends that are more likely to yield a big return. That’s why it’s common see so much venture capital and angel investment activity around technology companies, because they have the potential to be a huge win.
Conversely, other types of industries may yield great businesses, but not giant returns. A landscaping business, for example, may be wildly successful and profitable, but it’s not likely to generate the massive return on investment that a VC needs to make its fund work.
The other reason VCs tend to invest in a few industries is because that is where their domain expertise is the strongest. It would be difficult for anyone to make a multi-million dollar decision on a restaurant if all they have ever known were microchips.
When it comes to big dollar investing, VCs tend to go with what they know.
VCs know that for every 20 investments they make, only one will likely be a huge win. A win for a VC is either one of two outcomes:
VCs need these big returns because the other 19 investments they make may be a total loss. The problem, of course, is that the VCs have no idea which of the 20 investments will be a home run, so they have to bet on companies that all have the potential to be the next Google.
Unlike a bank that takes all interested customers, VCs tend to be far more selective in who they take pitches from.
Often these relationships are based on other professionals in their network, such as angel investors who have made smaller investments in the company at an early stage, or entrepreneurs whom they may have funded in the past.
VCs will expect entrepreneurs to be very buttoned up. After all, they're writing big checks to a small number of companies, so they have the luxury of only investing in the well-prepared businesses.
While some VCs will take pitches from an unsolicited source, it’s best bet to find a warm introduction through a credible resource. The VCs are the big leagues, so founders will want to make sure they do everything to make the most of their time in front of them.
Startup founders often have to “wear many hats” — meaning they have to do multiple jobs at once. They also have to learn on the job, like a startup may be founded by a designer, but that designer suddenly has to learn marketing, too, because they can’t afford a marketer yet.
But VCs usually invest in areas that they’re at least a little bit knowledgeable — if not extremely knowledgeable — about. And even if their knowledge of the field your startup is in is limited, they’re absolutely experts in the startup ecosystem as a whole.
When a VC comes on board with a startup, then, they bring all of that institutional knowledge with them. And that can be truly invaluable for a new company.
In addition to knowledge, VCs also bring their entire network to the table.
Maybe they know an amazing backend developer who’s looking for a new project, right when your developer leaves or right when you’re ready to scale up. Maybe they know other investors or potential customer bases or businesses your startup can partner with.
When you a bring on a VC, you’re bringing on all of their resources and connections, too.
This one is maybe the most obvious, but a big advantage of venture capital is that it’s a source of a lot of funding. And that large amount of funding can help your startup grow faster and at scale in a way that can be difficult without funding.
Another huge advantage of venture capital is that, unlike a loan, you don’t have to repay the money. So if your startup fails — and remember, the majority of startups do fail — you’re not stuck holding a bill for thousands or millions of dollars.
While other private investors might be a little… shady, that’s not usually the case with venture capital. Due to strict supervision by regulatory bodies, you can rest more easily knowing that your VCs are probably playing by the rules.
While it can be really difficult to find angel investors, venture capital firms are easy to find. You can literally just plug “venture capital firms” into any search engine and come up lists and lists.
Now actually getting their attention? That’s another story.
One major disadvantage of venture capital is that when you take on a VC firm, you’re trading equity for that funding.
So while you technically don’t have have “pay back” the money, you are paying for it.
When you bring on VCs, you’re also giving them a say in how you run your startup. They’re going to want to protect their investment and if their perspective on the best way to do things doesn’t match yours, things can get messy.
If your investors gain more shares than you and your co-founders have, it’s possible for you to lose ownership of your company. It’s worth considering as you’re contemplating bringing on venture capitalists.
One way that VCs protect their investments is by adding a member to your team — a member that, ultimately, answers to them. Of course, not all firms do this. But it’s not uncommon and it’s another consideration to make when you’re thinking about taking VC money.
Some startups like to stay in stealth. (We don’t recommend it, but it’s definitely a thing.) And if your startup is trying to stay stealth, it’s standard to have people sign an NDA after you give them information about what you’re doing. However, a potential disadvantage of working with VCs is that they may not want to sign a NDA.
VCs are all about high risk, high reward. But due to risk, they also may take a long time to decide to invest.
The process of raising VC money is a notoriously grueling one, with some startup founders having to tap out before they’re able to raise the funds. While venture capital is a great source of funding for startups, that long period of time before getting funding can be a serious disadvantage to venture capital.
While some venture capital deals result in startups getting all of their funds at once, many others will release it over a set period of time. Some contracts will have specific clauses about your startup meeting certain metrics before you can get the next round of funding.
From the investor’s perspective, that makes sense. They’re able to set requirements throughout the process and hold entrepreneurs accountable.
But from the founder’s perspective, it can be frustrating to know that the money is there, but not accessible.
Taking on venture capital means taking on the expectations of VC firms. And one of those expectations may be an ROI (return on investment) within the next three to five years. If your startup is positioned to do that, great! But if it isn’t, that expectation can cause a lot of stress.
Want to learn more about venture capital? Don’t miss our comprehensive guides on one of the most popular types of startup funding!