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Venture capital (VC) is a form of financing that provides startups and early-stage companies with high growth potential with money and usually expertise. Investors provide capital in exchange for preferred stock ownership in the company.
Here you can read more about how venture capital works, its pros and cons, and the differences between venture capital and other types of financing.
How does venture capital work?
The venture capital process begins with a startup pitching to a venture capital firm, which then evaluates the company and conducts due diligence before investing in exchange for equity. After providing financing, venture capitalists can play an active role in the company by providing guidance and support and possibly serving on the board of directors.
VCs generally try to exit the company within a certain period of time, usually by initiating an acquisition, merger or an initial public offering (IPO). In 2023, the median time from initial financing to IPO was 5.1 years for U.S. companies, according to a report from WilmerHale using data from the SEC and PitchBook. However, some companies never make it to an IPO and may fail completely. On the other hand, a very rare number will become “unicorns” and reach a $1 billion valuation.
“Venture capital tends to be a particularly risky part of the market, and given this risk, the returns for a successful investment can often be quite high,” says James Royal, lead writer, investing, at Bankrate. “Because of that risk, however, even smart venture capital firms must put their eggs in many different baskets to find attractive total returns on their portfolio.”
“For example, out of a portfolio of 10 companies, five or six may have total losses, while two or three may recover their investment,” says Royal. “There are then only one or two investments left that determine the total return of the portfolio. Finding a unicorn is therefore an important driver for the total return.”
Successful investment companies typically have a strong management team, great market potential and a unique and competitive product.
The 5 phases of venture capital
- Phase 1: Pre-seed capital
- The first phase usually involves raising the initial funding needed to start a business and is sometimes called the “friends and family” round because investments often come from the founder’s personal network. The money raised in this phase is often used for market research or team expansion.
- Phase 2: Start-up capital
- This is the stage where companies receive money from venture capitalists and is also called a Series A funding round. Most companies release product prototypes to consumers at this stage.
- Stage 3: Early stage
- The money in this phase – often called a Series B round – is largely used to produce goods and increase marketing for the company.
- Phase 4: Expansion phase
- Companies in this stage usually have a solid customer base and a proven track record. Investors are more interested in getting involved with companies at this stage because investing here is less risky than in earlier stages. Phase 4 may include Series C and beyond.
- Phase 5: Mezzanine floor
- An IPO or takeover usually takes place in this final phase. Companies in this stage have typically grown into successful businesses, and investors in this stage are likely to sell their shares to make a profit.
There are five general stages of venture capital financing:
Benefits of venture capital
Venture capital can provide significant benefits to small businesses and startups that struggle to obtain financing through conventional means. Here are some benefits.
Provide early financial support
Early-stage companies, which often do not have an established track record, can benefit from venture capital by accessing the financing and support needed to turn ideas into profitable businesses.
Exposure to valuable resources
In exchange for a potentially high return on investment, venture capitalists are happy to take on investment risks. They not only provide financial support, but also provide valuable management and technical resources – and their networks – to ensure the success of the investment.
No obligation to refund
Venture capital financing generally does not require a personal guarantee or collateral. This means that if a startup goes bankrupt, the founders are not obligated to pay back the venture capital investment.
Disadvantages of venture capital
Despite its advantages, venture capital has a number of disadvantages.
Loss of controlling equity interest
A major disadvantage is the potential loss of ownership control for founders. When obtaining funding from venture capitalists, founders may have to give up a significant portion of their ownership.
Time consumption
Securing funding from venture capitalists can be a time-consuming process, which may not be a suitable option for companies in urgent need of funding.
Expectations are high
The future availability of funds may be limited as venture capitalists often expect a significant return on their investment within a relatively short period of time, often five years. Subsequent rounds of funding may not be immediately available after the initial investment. Rapid growth is also often expected, which can increase pressure on the company. Underperforming companies that fail to secure additional financing may be forced to cease operations.
Limited leverage
Founders may have limited influence because venture capital terms heavily favor the investor, although the investor’s participation may be critical to the company’s success.
Venture Capital vs. Angel Investment
Venture capital and angel investing are both forms of financing for startups and early-stage companies. Unlike angel investors, who typically invest as individuals, venture capital firms pool funds from different sources.
Angel investors are often wealthy individuals with entrepreneurial experience who are willing to take higher risks. They typically invest small amounts compared to venture capitalists and may not require immediate repayment if the venture fails. Angel investors often provide entrepreneurs with not only financing, but also mentorship and advice, drawing on their own expertise and networks.
However, sometimes angel investors would rather not play an active role in the startup. While both venture capital and angel investing support startups, venture capital is more institutionalized, involves larger investments, and generally involves a longer-term commitment.
Venture capital versus private equity
Although venture capital is sometimes considered a form of private equity, venture capital firms target very different companies for their investments than private equity firms. Venture capitalists primarily focus on backing startups, while private equity investors typically focus on established companies.
Venture capitalists typically seek a minority stake in a company and require a shorter holding period in addition to their smaller investment. In contrast, private equity investors generally demand a higher percentage of ownership and a longer holding period.
In short
Venture capital can be a smart way to finance a business, but before you make a decision, you should first understand the difference between venture capital, angel investing, and private equity. Whichever financing route you choose – and many companies use a combination of all three – make sure you do your research and consider the potential tradeoffs.
