The Basics of Venture Capital for Small Businesses

Learn how venture capital works, different types, and how to tap into the market

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Venture capital (VC) is a form of equity financing used by small businesses and startups that anticipate high growth and a need for significant funding to sustain that growth. While VC funding is often thought of as financing for new, startup companies, it is also used by businesses that are at other points in their development.

In return for investing in a company, venture capitalists want a seat at the table and a return on their investment. If you are invited to make a pitch to a venture capitalist for financing, they will negotiate a deal with you. That deal will usually include a seat on your board of directors and a percentage of the return you earn, possibly laddered up or down through the coming years along with other stipulations.

VC funding is an important resource if a business is engaging in a risky venture and would have trouble qualifying for a bank loan or some other form of capital. Venture capitalists are typically high-stakes investors who are looking for a high rate of return on investment (ROI).

What Is Venture Capital?

Venture capital is a type of equity financing provided by private investors to startups and small businesses. These private investors may be individuals, VC firms, or other financial institutions. Small businesses often have difficulty finding financing for their operations, particularly if the firm is selling a new product or service that may be viewed as risky. It is considered to be equity capital since the venture capitalist typically takes a percent of ownership in the company commensurate with their investment. In contrast, debt financing is when a company borrows money to finance its operations.

VC firms pool investment dollars from investment companies, pension funds, large corporations, university endowment funds, and wealthy private individuals and use these funds to invest in high-risk companies that they think will be profitable. These pooled funds are often called private equity. Individual venture capitalists tend to be wealthy investors who take an interest in an innovative product or service and are willing to take on substantial risk in anticipation of a high return.

Many well-known companies, like Shopify, the popular online shopping cart company that launched in 2004, started out with VC funding.

How Venture Capital Works

VC funding has been a primary initial driver for some of the most successful, innovative, and influential businesses in the U.S., including Alphabet, Apple, Amazon, Facebook, and Microsoft.

Without VC funding, a lot of the research and development that goes into products and services wouldn't move forward, which can hinder many innovations that are deemed risky from actually making it off the ground.

Contrary to popular opinion, more VC is available as follow-up funding for projects and services originally funded by governments and corporations.

The VC funding process includes the following steps, though more may be added or some excluded depending on the deal:

  1. Introduction: In order to have a chance at obtaining VC funding for either a startup or a company previously funded in another way, the entrepreneur has to have an introduction made to a venture capitalist by a party that knows both of them, perhaps a principal in another corporation. The quality of the introduction is important and will determine if the venture capitalist is interested in the deal.
  2. Call with an individual or partner: After the introduction, if the individual venture capitalist or the partner in a VC firm is interested, you will then have a telephone call.
  3. Call for a pitch deck: If the call goes well and there is interest in your project, you will be asked to submit a pitch deck or presentation. You can see a sample pitch deck here. If the individual or partner is satisfied with the pitch deck, then you will meet with them and answer any questions.
  4. Term sheet: If you answer their questions to their approval, you will be given a term sheet. A term sheet states the terms for a possible offer of funding, but keep in mind that it is a non-binding agreement. You can find a sample term sheet here.
  5. Due diligence: After you are given a term sheet, the venture capitalist will perform their due diligence. Due diligence is the process of investigating your business to determine if the VC firm's investment has a good chance of being profitable.
  6. Offering documents: After due diligence is performed, and if the venture capitalist is satisfied, then you will be sent offering documents stating all the terms of their offer to you including the amount of funding and the other terms of the offer such as the percentage of equity they will own, whether or not they require a seat on your Board of Directors, and the other items on the term sheet, which may have been changed.
  7. Decision: You make a decision about whether to accept or reject the offer. If you accept it, funds will be transferred to your bank.

Due diligence can be a very rigorous part of the process for startups that includes detailed business and legal screenings. If VC firms decide not to move forward with funding after due diligence, they may offer their mentorship. And for payment, they may require a share of the business's equity.

What Are Venture Capitalists Looking For?

Venture capitalists are interested in businesses they believe will turn into solid investments. Since VC firms take on so much risk when they make an investment in a startup, product, or even in a growing business, they look to earn a very high return. Because VC firms are only interested in projects with very high growth potential, mom and pop businesses and corner grocery stores are generally not considered viable candidates for funding.

Candidates for VC financing include businesses that the venture capitalist believes will eventually be bought by another corporation someday, or those that have the potential to be taken public and funded by selling shares on the stock market in the future.

Venture capitalists typically expect 10 times return of capital over five years—while the National Bureau for Economic Research says that most probable return over time is 25%. They want either a seat on the board of directors or to be a board observer, who has the right to attend board meetings. VC firms may also want a liquidation preference, which means that if a business fails, the former will have all rights to the latter's assets and technology. In addition, VC firms may want guarantees that they will always be able to maintain their initial equity position.

Types of Venture Capital

Seed Financing

Seed financing or funding occurs in the initial phase of an idea for an innovative product or service. It is reserved for product or service ideas that the venture capitalist is very excited about and feels that it will do very well in the market. Seed capital covers research and development costs associated with the idea and initial expenses such as conducting market research.

Startup Financing

Startup financing occurs when the project has one full-time member of the management team working on it. That entrepreneur should be actively searching for other members of management to hire. At this point, the project, in the case of a product, should be in the prototype testing and finalization phase.

First-Stage Financing

In this stage, the product or service sold by the company has been fully launched, the company is 2-3 years old, but the goal now is to ramp up production and sales. The VC funding goes toward this by helping build the infrastructure of the company and distribution system, and covering marketing expenses.

Second-Stage Financing

Second-stage financing takes place when a business's product or service a business is selling very well. The financing goes toward the expansion of the business. It could be as simple as increased marketing expenses or as complex as entering new markets.

Mezzanine (Bridge) Financing

Mezzanine financing is used at the end of a VC firm's association with a company. It is used to either prepare a company for an initial public offering (IPO) to take it public. It can also be used to prepare a company for its sale to another company.

Pros and Cons of Venture Capital

Pros
    • Large amount of equity financing is provided
    • Valuable business expertise is available to the business owner
    • Faster growth and success happens due to wealth and expertise
    • Networking benefits due to business connections


Cons
    • Loss of control of ownership occurs due to equity stake.
    • The entrepreneur may have minority ownership
    • Obtaining venture capital is a lengthy and complex process
    • The benefits of this form of financing are mostly long-run


How Small Businesses Can Obtain Venture Capital

VC firms often get a large number of proposals from small businesses so it can be difficult to capture their attention. The best way to do so is to get a referral from a financial professional. You should talk with your banker, lawyer, certified public accountant (CPA), or another financial professional. One of these experts will probably be able to make a referral for you. Some venture capital firms focus on one geographic area or one or two specific industries. Your financial professional will be able to sort that out for you.

Some of the top venture capital funds include:

More complete lists, along with reviews, are located here. You can also attend private equity conferences and industry events and find out how other professionals in your industry attracted venture capital. The venture capital market is very much a networking and personal introductions market.