Venture Capital Funding
- Last Updated: Wednesday, 20 January 2021
High-growth, start-up companies are often looking for money and management experience. That's a void venture capital firms are willing to fill. As is the case with angel investors, venture capital firms are willing to absorb the higher risk associated with start-up companies in exchange for higher returns on their investments.
In this article, we're going to be covering the topic of venture capital (VC) investing. As part of that discussion, we'll first talk about the role venture capital plays in funding the growth of small businesses; including statistics demonstrating the impact these investors have on small business growth. Next, we'll talk about the structure of contracts or agreements. Finally, we'll discuss how companies can go about finding venture capital firms.
Business Investments and Venture Capital
It's surprisingly difficult for a small business to grow rapidly. Their ability to expand operations is limited by their own profitability. This dilemma is quite real. For example, in order to increase profits, a business might need to expand their manufacturing plant operations. But the capacity of their existing plants does not allow them to make enough profit to finance new plants at the desired pace.
This is the very reason many small businesses seek new sources of capital to meet the rapidly growing demand for their products. Business owners frequently do not have enough money to fund this expansion themselves, and traditional lenders shy away from the risk of start-up businesses. This is where venture capital firms come into play.
Angel Investors versus Venture Capital
A small business looking for funding beyond traditional financial institutions has three options. The more money borrowed, the more rigorous the application and approval process. In addition, each non-traditional lender will have both a lower and upper limit to the amount of money they're willing to lend a small business. That hierarchy of lending is generalized below:
- Friends and Family: can be sufficient when the capital funds needed are less than $100,000.
- Angel Investors: wealthy individuals may be willing to invest as much as $1 million in a start-up or growing business.
- Venture Capital: a pool of investor money, usually limited to investment opportunities in excess of $1 million.
There is some overlap between angel investors and friends and family, but venture capital firms will usually not consider investments under $1 million. The investment that friends, family members, and angel investors are willing to make is limited by their own personal wealth. Venture capital organizations are limited by their firm's guidelines.
Structure of Firms
Venture capital firms involve a large number of investors. The money contributed by these individuals is pooled together to form the fund. These firms are usually structured as partnerships or limited liability companies (LLC). Within that operating structure, there are specific roles and responsibilities including:
- General Partners / Managing Members: executives of the firm that frequently act as primary investment advisors too.
- Limited Partners: entities that are willing to contribute to the funding of the firm. This includes wealthy individuals, pension funds, university endowments, insurance companies, and even mutual funds.
- Venture Partners: members of the firm that are compensated for finding successful investment opportunities.
- Entrepreneur-In-Residence: subject matter experts involved in the evaluation and communication of investment opportunities.
- Principals / Associates / Analysts: mid-level and entry-level positions in the firm that help with the daily operation of the company as well as the evaluation of investment opportunities and emerging technologies.
Employees of the VC firm are compensated through annual fees paid by limited partners. Fees are considered quite generous, typically 2% of the committed capital.
The National Venture Capital Association (NVCA) publishes statistics on venture capital deals and funding throughout the year. This information is re-published by government agencies such as the Small Business Administration. The NVCA gathers information from more than 400 venture capital firms throughout the United States.
According to the 2019 statistics compiled by the NVCA, there were 10,430 VC investment deals worth a total of $133 billion. That works out to an average deal of $12,752,000.
Working with Firms
It's not easy to obtain funding from a venture capital firm. A good rule of thumb is that for every 100 business plans evaluated, only ten plans make it through the initial screen and are further analyzed. Of the remaining ten plans, only one company will receive funding. This means there is only around a 1% chance a company will be successful in receiving funds.
Venture capital firms expect to liquidate each investment it makes in three to seven years. Exit strategies include selling stock, Initial Public Offerings (IPOs), and acquisitions by another company. In any of these scenarios, the firm will cash-out their position in the startup company and the investment cycle for this money begins once again.
Stages of Financing
As a startup company moves through its lifecycle stages, so can the VC financing. The sequence below demonstrates this possibility:
- Seed / Concept: the business is still in the ideation stage or the product / service is not completely developed. This money is typically used to help the inventor or owner to develop a working prototype.
- Stage 1: the company has launched its product or service, and a permanent management team is in place. Funding at this point is used to help the company achieve economies of scale, thereby reducing costs and increasing profitability.
- Stage 2: sales are increasing rapidly, inventory is building, and the company is ready to start expanding operations into new markets.
- Stage 3: product is maturing, sales are continuing to climb, product is an obvious winner in the marketplace, and funding is used to continue expanding capacity.
At this point, the VC firm begins to carry out their strategy to liquidate their investment in the business. Preparations are made for an IPO, sale of stock, or acquisition.
When first looking for a venture capital firm, it's best to work with a local organization. Across the United States, organizations are grouped by region, but there are several national communities that provide support to these firms.
Before approaching a venture capital firm, it's important to have a solid, well-written business plan. The company must also have a permanent management team in place. Some VC firms will invest in relatively narrow business segments. Of current interest are biotechnology, medical devices, software, clean technology, alternative energy, and the Internet. The odds of success increase when there is a match between the industry specializations of the VC firm and the emerging business.
The below list are national associations of small business, seed money and venture capital firms:
- National Venture Capital Association (NVCA): consists of more than 400 members in the VC industry. The stated mission of the NVCA is to "foster greater understanding of the importance of venture capital to the U.S. economy..."
- National Association of Small Business Investment Companies (NASBIC): a professional association of the Small Business Investment Companies (SBIC), one of the oldest venture capital organizations in the world. NASBIC plays an important role in building a strong foundation of capital funds for America's small businesses.
- National Association of Seed and Venture Funds (NASVF): a global, non-profit organization consisting of 600 members in 43 states. The NASVF promotes investments in early-stage companies through the creation of jobs and the formation of capital programs.
About the Author - Venture Capital Funding