Running a business comes with a lot of challenges. Around 20% of new businesses fail during the first two years of operation, and only 34% of them make it to their 10th anniversary. According to Investopedia, one of the main reasons for this failure is the lack of capital.
Because of that, small companies are encouraged to find external funding sources to help them jump-start or expand their business. One of the funding types you might want to consider is venture capital. But what is it, and how does it work?
In this article, we will look at how venture capital works and how to obtain this funding for your business.
What is Venture Capital?
Venture capital or VC is a type of investment or private equity designated to startups or small-scale businesses that are deemed to have a high potential to grow. This investment typically comes from financial institutions or high-income individuals, and these investors are usually called venture capitalists (VCs).
This funding will be pooled together by dedicated investment firms. Venture capital may also come in various forms other than financial investments, including technical or managerial expertise. Even though venture capital is considered a risky investment, the high return potentials can be an attractive payoff for VCs.
This is clear from the significant increase in global venture investments, which reached around $125 billion in the first quarter of 2021. According to Crunchbase, this is a 50% increase quarter over quarter and a whopping 94% increase year over year.
Some of the most popular businesses that might attract VCs include mobile application development, digital marketing agencies, and web hosting providers. VC funding has also helped many large companies like Apple, Amazon, and Microsoft in their early stage of business.
How Does Venture Capital Work?
In venture capital, the investors take a certain percentage of ownership in the company equal to their investment. This is different from debt financing, where the company simply borrows money from investors to help its initial capital.
Since venture capital is considered a risky investment, VC firms will only provide funding for a company or project with very high growth potential. VCs are also interested in startups that might be bought by a larger corporation or taken public in the future.
Depending on the company’s size, growth potential, and the amount invested, VCs will typically take between 25 to 55% of the company’s equity ownership.
Types of Venture Capital
There are three main groups of venture capital depending on the business’s stage, including:
Early Stage Funding
The early-stage funding is divided into three different subtypes:
- Seed financing. Seed financing is a small amount granted to help a start-up reach the next round of funding. This financing process typically occurs when the product or service is still a concept.
- Startup financing. Startup financing occurs when the project is in the prototype testing and finalization stage. It is given to the entrepreneur to help them finish their project development process.
- First-stage financing. The main purpose of first-stage financing is to help a small business boost its production and sales. The beneficiary can use this funding to cover initial operational, infrastructure, and marketing expenses.
Expansion funding or second-stage financing is intended for an established company. It is typically used to help a business reach a new level of growth, such as increasing its marketing efforts or entering new markets.
As the name suggests, acquisition funding is intended to assist a company in acquiring certain parts or an entire company. A small business can grow significantly by owning another company’s products or services and gaining its market share.
How to Obtain Venture Capital Funding
The VC funding processes typically require several steps.
Business Plan Submission
The first step in VC funding is to submit a business plan to the venture capital. This business plan typically includes the executive summary, market opportunity, expected competitive scenario, financial projections, and details of the company’s management.
The VC will conduct an in-depth analysis of this business plan and decide whether the funding will proceed or not.
Once the VC decides that the business plan fits their preference, there will be a meeting to discuss the submitted business idea in detail. If the business owner can introduce their business properly and convince the VC, the funding will proceed to the next step.
Due diligence is the process of investigating your business to determine if the VC firm’s investment has a good chance of being profitable. This includes analyzing aspects such as customer references, product and business strategy evaluations, management interviews, and legal screenings.
Due diligence can be a very rigorous step for the business. Thus, if the VC firms decide not to proceed with the funding, they may offer mentorship with a share of the business’s equity as the payment.
Term Sheets and Funding
Once due diligence is completed, the VC firms will offer a non-binding document called term sheets that contains all the offer details. This includes the amount of funding and the other terms of the offer, such as the percentage of equity they will own.
These terms are mostly negotiable and need to be agreed upon by all parties. Once the business owner accepts the term sheets, the funds will be accessible.
The most important factor to consider when looking for capital funding is networking. For example, gaining a referral from a financial professional such as a banker and certified public accountant can significantly make the funding process easier.
Venture capital can be a helpful source of funding for small companies to help them jump-start or further grow their business. Even with the relatively high risk, venture capital is still popular among investors due to its high return potential.
In this article, we have learned about how VC works and its three main types. We also looked at the most common steps in obtaining VC funding, including:
- Business plan submission
- Introductory meeting
- Due diligence
- Term sheets and funding
Small business owners need to fulfill these processes properly and present the project or business with a good risk-return ratio to ensure funding from venture capitalists.
Hopefully, this article has helped you understand venture capital better and introduce its benefits for your business.