How Does Venture Capital Financing Work?
After reading this post, you’ll understand what venture capital financing is and how it works. In addition, you’ll discover what kinds of companies typically attract VC funding and how these deals are structured.
What is Venture Capital?
Venture capital, like any other kind of capital, is cash or liquid assets that create value or benefit for their owner. What distinguishes venture capital from other funding types is that venture capital is provided by private investors to business owners. This venture capital is in exchange for equity.
Venture capital firms are similar to, but not the same as, private equity firms. Like VC companies, PE firms invest in companies in exchange for equity. However, PE firms take less active roles and invest in smaller proportions compared to VC companies.
Another type of business financing commonly confused with VC is angel investing. Angel investors are high net-worth individuals, like Mark Cuban, who invest in early stage companies.
How Does Venture Capital Work?
There are two parties named in a venture capital deal, the company and the venture capitalists. The venture capitalists invest a certain sum of money in exchange for a certain ownership proportion, or equity. As part of the deal, VCs gain some level of control of the company they invest in.
VCs also often support the companies they invest in by providing strategic guidance and making introductions.
Of course, venture capitalists aren’t investing their own money into businesses. They’re investing the money of a group of investors from whom they have collected a pool of money. This is called a fund, and VCs are responsible for investing it based on an agreement with their limited partners.
Generally, investors in VC funds are large institutional investors such as financial firms, insurance companies, and pension funds.
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How Are Venture Capital Deals Structured?
In a typical start-up deal, a VC fund could invest $3 million for a 40 percent preferred equity ownership.
This kind of VC deal includes downside protection for the venture capitalists. This includes mechanisms like a liquidation preference and/or anti dilution clause.
Liquidation preference enables the VCs to liquidate all the company’s assets and technology if the company fails. Anti dilution clauses guarantee the VCs can maintain their original equity percentage. However, this is only if the company is required to raise money at lower valuations.
VC investors also require upside provisions, like the ability to invest additional money at an agreed-upon price. Of course, there are many, many variations of this basic deal structure.
Types of Companies that Attract VC Funding
VC fund investors expect annualized returns of 25 to 35 percent. Given this high bar, fund managers must be extremely selective about what companies they invest in. At a high level, the way fund managers invest is focused on the industry and the company’s growth stage.
Only a small portion of industries can achieve the type of growth VC funds require to satisfy their investors. In fact, experts estimate that less than 10 percent of economic activity will grow by 15 percent or more annually.
As economies change, so do the types of companies that attract VC funding. In the early 1980s, most VC investments went to energy companies. However, by the late 1990s, the focus shifted to internet companies.
These shifts in capital flow might seem random, but they’re actually following predictable patterns towards the highest growth rates.
Usually, high risk companies have trouble raising capital through VC funding. If your industry or business structure seems unstable, this funding typically will be hard to attain. Instead, you may have better luck asking friends and family for money to help you start your business venture.
Conclusion: Consider Venture Capital Financing for Your Business
Even for hyper-growth companies that could generate high returns, it’s challenging to attain venture capital financing. For companies with more gradual growth profiles, VC financing is simply not a viable option.
As it is, the majority of companies that VC funds invest in—called portfolio companies—fail. In fact, Pocket Sun, the Co-founder of SoGal Ventures, estimates that 90 percent of portfolio companies fail.
This failure rate persists even though VC funds restrict their investments to hyper-growth companies. If VC funds were to branch out beyond these industries, they simply couldn’t meet their investors’ mandates.
Not only that, venture capital money comes with lots of strings attached. Unlike a lender who only requires that you pay your loan back, VCs take a significant controlling interest in your company. Depending on the deal structure, VCs can take over your company, force a sale, and/or rearrange your management structure.
In conclusion, if you’re in a hyper-growth industry, VC is worth considering. However, you should be fully aware of what you’re getting into. The real world of venture capital is far different than the romanticized version popularized on TV and in the movies.
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