Key takeaways
  • Early-stage startups typically cannot access loans or capital markets directly, so they rely on VC funding instead.
  • In exchange for VC funding, founders offer investors a percentage of ownership and perhaps a board seat.
  • VCs can be a critical source of funding, but there are other paths you can use to achieve success.

What is venture capital?

Venture capital (VC) is a type of private equity used to support startups and early-stage companies with the potential for substantial and rapid growth. Venture firms raise funds from limited partners (LPs) to invest in these high-potential business, often providing not just financial backing but also technical support and managerial expertise.  

In return for their investment, VC firms gain ownership stakes in the companies they support. Venture capital is typically introduced at various stages of a company’s development, such as seed and early funding rounds, and plays a critical role in driving innovation and expansion across industries. 

 The Venture Capital Process v 4

What is an example of venture capital?

In 2018, an $88 million Series A funding round was raised for Roman Health Ventures, a telehealth company focusing on men’s health. By 2021, Roman Health Ventures had raised over $500 million, expanding its services and cementing its position as a leader in the telehealth industry. This investment highlights how venture capital can fuel growth and innovation in emerging sectors. 

How does venture capital work?

When investing in a startup, VC funding is provided in exchange for equity in the company, and it isn’t expected to be paid back on a planned schedule in the conventional sense, like a bank loan. VCs typically take a longer-term view and invest with the hope they will see outsized returns should the company be acquired or go public. VCs usually take only a minority stake — 50% or less — when investing in companies, also known as portfolio companies, because they become part of the firm’s portfolio of investments.  

VC firms raise money from limited partners to invest in promising startups or even larger venture funds.

Another example is investing in larger venture funds. The larger venture funds can have a clear target in mind for the kind of companies they want to invest in, like an EV (electric vehicle) company. So, rather than invest in a single startup, they are investing in multiple companies.

What is the venture capital investment strategy?

A VC investment by its nature is risky and takes place before a company goes public or, in early-stage companies, even before a company has an established track record. The possibility of large losses — even the entire investment — is factored into the VC’s business model. In fact, VCs anticipate that they’ll lose money on most investments. The odds of hitting a “home run,” earning over 10X the venture capital investment, is small and can take years to realize. The calculation is that a few successful companies can pay dividends that far offset the losses. 

Despite the long odds, venture capital is a major economic engine that: 

  • Generates job growth 
  • Spurs innovation   
  • Creates new business models that change the world   

The funding VCs provide gives nascent businesses — and industries — the chance to flourish. They help to bring ideas to life and fill the void that capital markets and traditional bank debt leave due to the high risk associated with limited operating history, lack of collateral and unproven business models. VC funds play a particularly important role when a company begins to commercialize its innovation.  

What is a venture capital investment fund?

A venture capital investment fund is a pooled investment vehicle that primarily invests in startups and small- to medium-sized enterprises with high growth potential. These funds are managed by VC firms, which raise capital from LPs, such as pension funds, endowments and high-net-worth individuals. The goal is to generate significant returns for investors by identifying and nurturing companies that will scale rapidly and eventually provide a profitable exit through an acquisition or an IPO. 

Despite US VC investment falling below previous peaks, there is still more capital flowing to US startups this year than in 26 of the previous 30 years. This reflects a vibrant landscape for VC fundraising and investment, driven by a recalibration and recovery in the innovation economy. Non-traditional investors continue to expand their participation in the VC arena, including: 

  • Private equity
  • Corporate venture
  • Hedge funds
  • Sovereign funds 

The latest State of the Market report tells the story of this ongoing trend, highlighting the resilience of the venture capital market despite fluctuations in investment levels. 

Why venture funding?

Tapping venture capital is a logical choice. There are many sources and, as noted above, non-traditional investors are joining an already large mix of traditional VC firms. Many funds target a specific industry or sector, geography or stage of company development. Many connections are made through startup networking groups, accelerators and mentoring programs. Among the first items is to create a pitch deck and target firms that appear to be good fit for your company and business model.  

If an investor is impressed by your pitch deck and business plan, they will do their due diligence to verify your point of view. This will include a full analysis of your business model, products or services, financial position and performance — now and in earlier ventures.  

Suppose the decision is made to go forward. In this case, the venture investor will present a term sheet that will include: 

  • The venture capital investment amount they are proposing to make 
  • The equity stake in the company that they expect in return   
  • Other conditions of the deal  

There may be conditions you need to meet before they release their funds, including additional fundraising on your part. You should expect that VC money can be structured to come in multiple rounds over several years. 

Most terms are negotiable; however, you should prioritize those that are the most important to you and your partners, particularly other financial partners. Be specific and realistic when you’re negotiating, or you run the risk of coming across as inexperienced or overly confident. Either way, this can lead to getting off on the wrong foot with your new VC partner.  

Stages of raising capital

Pre-VC funding: At the start, companies often “bootstrap” their operations. Funds are provided by the founder and founder’s friends and family who want to be supportive and hopefully are confident that the young company will succeed. However, there comes the point where the fledgling company needs to scale, sometimes years ahead of profitability. At this point, founders seek more formal sources to finance their growth. 

Pre-seed stage: Typically, modest early-stage funding is for product development, market research or business plan development. The pre-seed stage is to prove product/market fit, to test the waters, and to see if there is a market for what you are creating. It is called a “pre-seed round,” and the fund source is typically a microVC or angel investor. In exchange for their pre-seed round, investors are usually given convertible notes (short-term debt financing that may be convertible to equity), equity or preferred stock options.  

Seed stage: This money supports growth during your first expansion phase. The funds are usually significant and are meant to address the capital needs for operations such as hiring, marketing and operations once a company has a viable product or service. This venture capital is also known as Series A funding, with future rounds known as Series B and so on.   

Late stage: This funding is for more mature companies that have proven a substantial ability to grow and generate revenue, and sometimes profits. VC firms tend to be less involved in late-stage funding. Typically, private equity firms and, more recently, hedge funds would become involved at this point because the risk is lower and the potential for hefty returns is higher.  

What does a venture capitalist do?

Although you may have few funding alternatives, if you’re looking to scale your young startup quickly, then working with a VC firm can offer other advantages.  

  • Expansion capability 
    If you have high initial costs and limited operating history but significant potential, venture capitalists are more likely to share your risk and provide the resources for success.   
  • Mentoring  
    In addition to funding, venture capitalists are a valuable source of guidance, expertise and consultation. Often, they have worked with many startups and investors during good and bad cycles. They can help: 
    • Build strategies 
    • Extend technical assistance  
    • Provide resources and additional investor contacts   
    • Help recruit talent   

They are committed to your success since their investment only performs well if you do.   

  • Networks and connections
    Venture capitalists typically have a huge network of connections in the innovation economy. They are willing to make introductions and give references to help you find: 
    • Advisors 
    • Funding resources  
    • Skilled talent  
    • Business development connections to help you scale   
  • No repayment 
    Unlike loans requiring a personal guarantee, if your startup should fail, you are not obligated to repay venture capitalists. Likewise, there are no ongoing monthly loan repayments. Again, this helps to facilitate your cashflow and chance for success. 
  • Confidence
    VCs are regulated by the US Securities and Exchange Commission (SEC) and their financing mechanisms are subject to similar regulations as private securities investments. In addition, Know Your Customer (KYC) and anti-money laundering regulations also apply when venture capital funds are provided by depository institutions or banks.  

The cost of venture capital

Obtaining VC funds can be a long and complicated process. These investors are looking to become partners in your business and want to be confident that your team has the resources, market potential and business skills to create success. They also seek an eventual payout from the investment that is sufficient to cover the risk they are assuming.  

  • Dilution of ownership and control  
    As means for protecting their investment, venture capitalists will take a slice of company ownership and usually join your board of directors to give them a voice in your decision-making. Major decisions may require the consent of investors, and this can lead to uncomfortable conversations when opinions diverge.   
  • Early redemption   
    A VC who wants to redeem their investment within three to five years may not be well suited to provide support. Early-stage companies often need more time to deliver a profit or execute an exit.  
  • Timing   
    You need to set aside enough time to create (and rehearse) an effective pitch deck, develop a compelling business plan and then search for an interested VC who makes a good fit. The VC then needs time to do their due diligence and make their decision. After that, you’ll need a series of one-on-one meetings to review the plan and agree to terms before funding can commence.  
  • High return on original investment
    VCs who require a high return on investment (ROI) within a short time frame may cause stress that can impact your business decisions.  
  • Incremental funding  
    Most VCs will require that you reach certain business milestones before releasing subsequent rounds of funding. This assures them that you’re using funds wisely and growing as planned.  
  • Undervalutation
    Some venture capitalists are eager to sell their equity stake and may pressure you to exit through either a sale or an IPO. There are solutions to avoid a scenario that results in an undervalued exit.  

Conclusion

Whether you need VC funding depends on the nature of your business. If your startup requires heavy upfront investment — manufacturing facilities or a large sales team, for example — or will take years to realize commercialization and revenue, then seeking VC funding may be critical. 

Many startups are successful having never sought VC funds.

However, many startups are successful having never sought VC funds. In fact, according to Fundera, only a tiny percentage of startups raise venture capital. Funding alternatives can include: 

  • Commercial loans and debt vehicles  
  • Venture debt in conjunction with raising an institutional round (Series A) to reduce dilution  
  • Licensing deals and partnerships with corporations   

Some startups with low initial costs, like software, can get started with founder funding and scale using proceeds from sales.  

Be sure you understand how funding decisions made now will affect your company in the long and short term, so you can choose the course that best aligns with your mission and vision.