Take a look at the
early history of some of the most successful companies of recent decades, and
you’ll often see venture capital funding playing a crucial part. Apple, Google,
Facebook and Twitter are just some of the big names to have gotten a jump-start
from venture capital.
So what is venture capital? How does it work, what are the pros and cons of this funding method, and how can you secure venture capital funding for your business? You’ll get answers to all these questions in this tutorial. By the end, you’ll be in a good position to weigh venture capital against the other funding options we’ve looked at so far in our eight-part series on Funding a Business.
1. What is Venture Capital?
In our last tutorial, we looked at angel investors, wealthy individuals who pump cash into small businesses in return for a share of future profits. Venture capital (VC) works in a similar way, but now we’re talking about companies, not individuals, and that makes a significant difference.
First of all, the amounts of funding available are much higher. Whereas the average angel investor invests $520,000, the average venture capital deal ranges from $2.6 million for a brand new start-up to $10.3 million for a later-stage company.
Also, while the expected time frame and returns are similar—a 10 times return over five to seven years is a good rule of thumb—the venture capital firm is on a much stricter schedule.
To understand why, let’s look at the structure of a typical VC fund. Usually it raises money from a group of investors (“limited partners”) for a specific period, say seven to ten years. In that time, it invests in perhaps 10 or 20 companies and tries to grow them to a point where it can sell its stake for large profits. Then the fund is liquidated, and the limited partners get their money back plus—hopefully—a healthy return.
It’s a lot to accomplish in a short space of time, and that can mean significant pressure on you if your company is failing to deliver the expected growth. The fund isn’t going to prolong its life and delay returning money to its investors just because your development is behind schedule. The VC firm will take out what money it can when the time is up.
Venture capital funding peaked at more than $100 billion during the dot-com frenzy of 1999, but still amounts to more than $20 billion a year. The most popular sector by far is software, followed by biotech, energy and medical devices. Whereas angel investing is spread around the country, venture capital is heavily concentrated in California. There are still firms in most states, however, and in many countries around the world.
As the name suggests, venture capital is risky from the investor’s point of view. The National Venture Capital Association estimates that 40% of venture-backed businesses fail, 40% are moderately successful, and 20% produce high returns. The VC firms rely on that 20% to boost the performance of their overall portfolio.
2. Advantages of Venture Capital
VC has some important advantages over the other funding methods we’ve looked at so far in this series. Here are the main benefits of this approach:
Deep Pockets, Fast Growth
As we’ve seen, the average venture capital deal is about five or ten times larger than angel investments, and on a completely different level from most crowdfunding projects. Securing a few million dollars in VC funding can fuel spectacular growth, allowing your business to make serious investments in the best equipment, hire new staff and gear up for success.
Not only can you raise large amounts of money from venture capitalists, but you can also go back and ask for more, either from the same firm or from others. Twitter, for example, raised between $1 million and $5 million from its first round of venture capital funding in 2007, $22 million in 2008 and $35 million in 2009 (plus other undisclosed amounts). The company was growing quickly, and the extra rounds allowed it to raise larger amounts in line with its higher profile.
No Need to Repay
Unlike loans, venture capital funds don’t have to be repaid, and you don’t have to give personal guarantees using your own assets. That doesn’t mean it’s just a free hand-out, of course. If things don’t work out, you’ll find yourself under serious pressure to deliver some kind of return on the VC firm’s investment. But ultimately every VC firm knows that sometimes they just have to write off the money. In fact, Harvard Business School research suggests that this happens more often than the venture capital industry likes to admit.
As we saw with angel investors, it can be beneficial to have an experienced investor on board. They can bring not just money but also smart strategic suggestions, and a bulging address book of powerful contacts.
The same applies to venture capital firms. They’ve worked with dozens of other companies in your industry, and have helped at least some of them make it to the big leagues. They know what works and what doesn’t, and can help you avoid some of the common mistakes made by young, growing companies.
3. Disadvantages of Venture Capital
Although it has some powerful advantages, venture capital is not a magic bullet for your business. Just like all the other funding options in our series, it has several downsides you need to be aware of:
Difficulty of Raising Funds
Here’s the bottom line: most small businesses aren’t going to raise venture capital funding. Your business could be profitable and well run, with good long-term prospects, but it still won’t meet the criteria of VC firms unless it can deliver spectacular growth in a specific time period. Generally that means high-tech firms in the early stages of their development, with very compelling prospects.
Even some companies that seem to fit the bill may fail to raise funds, simply because the process is so competitive. The National Venture Capital Association says that there are just 462 active VC firms in the U.S., so there are a lot of ideas chasing a limited amount of funds. It’s tough to get accepted. You might spend months touring Silicon Valley with your PowerPoint presentation, only to end up with nothing.
Living Beyond Your Means
We saw a few weeks ago in the tutorial on self-funding a business that “bootstrapping” forces businesses to be disciplined about their spending and live within their means.
With venture capital, the opposite applies. When a young company gets a very large check, it can lead to unsustainable spending. You might be tempted to splurge on a cool office space downtown, hire staff on high salaries, and invest in expensive equipment. Pretty soon, you’re living way beyond your means, and need to make a huge amount of revenue before you can start to turn a profit. In the worst case scenario, you become dependent on the venture capital firm to keep funding your business, and if they turn off the spigot, your business folds.
Loss of Profits, Loss of Control
When you sign that agreement, you lose a share of your company—usually it’s a minority stake, but the venture capitalist could still take perhaps 10% or 25% of your company. If you do become successful, that’s a lot of money you’re giving up. Business owners often justify it by saying they’re happy to have a smaller slice of a bigger pie, but still it’s a cost that you need to be aware of.
Also, venture capital firms don’t just write you a check and leave you to it. As part of the agreement, they’ll often demand to be given a place in your management team or on your board of directors. You’re no longer in sole charge of your business: you now have to take account of the views of outsiders.
Conflict of Interest
As a business owner, you want your business to grow quickly and make lots of money, and in that way your interests are aligned with those of venture capitalists. But don’t forget that the venture capital firm is on a strict timetable, and wants to exit the business with a particular return by a particular date.
A favored exit strategy for VC firms is an IPO (initial public offering), which we’ll look at in more detail in a future tutorial. They can often sell their stake at a huge profit during the IPO, so may push you to hold an IPO sooner than you would have liked, or perhaps to sell your company to a larger firm like Google or Facebook if the price is right. Their interest is in securing a return on investment, and that can sometimes be very different from your long-term interests and those of your company.
4. How to Secure Venture Capital Funding
Find a VC Firm
The first step, of course, is to find a venture capital company to approach, or preferably a shortlist of several. You could start with this listing of more than 1,000 venture capital firms in different parts of the U.S. and all around the world. You can search by location, fund size, industry focus, investment stage, and investment amount.
There are also regional venture capital organizations around the country, and in different parts of the world, that may be able to help you find a local firm. This page has a good summary of organizations for you to try.
Keep in mind that venture capital firms get hundreds of pitches from hopeful entrepreneurs. Sometimes your idea by itself is strong enough to get people’s attention: WhatsApp, for example, which was recently bought by Facebook for $19 billion, didn't even have to seek venture capital funding. VC firm Sequoia Capital approached its founders and persuaded them to take a $60 million investment. (That investment was eventually worth $3 billion.)
Usually, though, you’ll have to work hard just to get your foot in the door. An introduction makes a big difference, so work your network to see if someone knows anyone who works in venture capital. Otherwise you’ll probably have to do a cold call to an associate in the firm, and try to get passed on to a partner, and then finally be invited to pitch formally to all the partners.
The key to a successful pitch is to show that your company has strong growth potential and a clear plan for making the VC firm a strong return in five to seven years. You want to get across your information quickly and clearly, without getting bogged down in detail.
For a detailed step-by-step guide on making a successful pitch, check out our tutorial How to Craft a VC-Ready Pitch Deck.
Working With VC Firms
If you’re successful in your pitch, then you’ll need to agree on terms. The most important element is setting the valuation for your company, as this determines how much of a share the VC firm gets in return for its investment. Silicon Valley entrepreneur Guy Kawasaki says that whatever you’re offered, you should always ask for 25% more—the venture capitalist will expect you to push back, and may even be worried if you don’t.
Once everything is agreed, it will be drawn up in a “Term Sheet” listing the key points of your agreement. The venture capital firm will do “due diligence,” which means investigating your company in detail and checking that all the information you’ve provided is accurate. Then you’ll close the agreement, and receive funding.
Often, you won’t get all of the money up-front. Sometimes it’s divided into “tranches,” portions which are released gradually depending on whether you’re meeting your targets. Even if that’s not the case, there may be some control mechanisms built into the agreement, so that the VC firm can assume control of your company if you fail to meet basic financial and operating targets.
This will usually be a last resort—venture capitalists want to be raising funds and looking for the next investment, not spending time running your company. But it’s important to be aware of what could happen, and make sure you run your business carefully to avoid any problems.
Research has found that the number one cause of start-up businesses failing is premature scaling, in other words trying to grow too much too soon. So don’t go crazy with the venture capital funding you’ve received. Make sure you don’t plow too much money into one area and neglect others. You want to keep your company well balanced, so that the growth is fast but sustainable.
5. Next Steps
So now you’ve learned what venture capital is and whether it might be suitable for your business. You’ve seen some of the pros and cons of raising money this way, and have some tips on how to find a venture capitalist, make a successful pitch and work with them to help your business grow.
Venture capital is not right for every company, of course. Many businesses simply don’t have the explosive growth potential that VC firms are looking for. And even if you are eligible, you may look at the disadvantages and decide it’s not for you.
If that’s the case, be
sure to read the other tutorials in our eight-part series on Funding a Business. We’ve covered five other options already, from bank loans to
crowdfunding, and there are two more coming up soon. Next week, we’ll take a
look at private equity.