There comes a time in the life of every business when it needs additional capital to grow. Where will this money come from? Many businesses turn to venture capital to provide the financial boost they need without saddling the business with debt payments. This guide will explain what venture capital is and why some businesses choose to pursue it.
What Is Venture Capital?
The definition of venture capital is the illiquid investment of capital and resources into a project or company that has a substantial element of risk. The traditional banking sector is not an option because of the inherent risks of startups.
With this increased risk comes great reward. It is commonly quoted that nine out of 10 venture capital investments fail. However, when an investment blossoms, it can make up for all of the others in the eyes of a venture capitalist. Venture capital firms typically invest with a target of 25 per cent to 35 per cent annual rate of return on their money to compensate for the risks they take.
The Venture Capital Process
The venture capital process is not for the faint of heart. If you decide to give it a shot, you need to open your business and management team to intense scrutiny while the VC firm decides whether or not your idea is worth it for them to invest.
It may sound coarse, but the literal and figurative payoff — finding someone to invest in your idea or business — is worth it. With the right VC firm as a partner in your business, you can receive the capital you need. Additionally, a proactive VC firm will introduce you to connections you otherwise would’ve never been able to meet.
These synergies could propel your business to heights you hadn’t imagined.
However, be aware that venture capital funds have a short time horizon. A VC firm’s goal is to invest their assets within two to three years, grow with you over the next couple of years, then liquidate their position within five to seven years.
The end goal for both parties is that a venture capital investment will cash out of the investment through the next round of funding, a merger or acquisition, or an initial public offering (IPO).
Venture Capital Funding Stages
“Venture capital” is a catch-all name that many people use. The reality is that there are different levels of venture capital. Each one is appropriate for a different stage of a company's growth.
Angel investors are affluent individuals who invest in companies or ideas individually or through angel groups or networks. These angels typically invest their own money and often take a more hands-on approach with their investments. If you've ever watched an episode of Shark Tank, you have seen an angel in action, albeit with a little more pizazz thrown in for the television cameras.
The seed funding round is designed to grow an idea into an actual business that generates revenue. Investments of $500,000 to $2 million are normal for seed funding. This money supports initial market research and developing the idea into a viable product or service.
As the business develops a track record of growing revenue, the Series A round scales the business to expand into additional markets with the focus of growing revenues. This round of funding is typically in the $2 million to $15 million range. This money allows management to execute the business plan and build toward profitability.
As the business matures, the Series B investment round is focused on taking the business to the next level. This investment, in the range of $7 million to $10 million, is meant to ramp up talent acquisition to give the company the key players necessary to execute its business plan.
These investments are designed to give a business the capital it needs to perfect its business model. The concept of the business is proven and considered less risky at this point. Capital raised ranges from $1 million to $100 million and can be used for a variety of purposes, including the acquisition of competitors for geographic expansion, intellectual property, or talent.
Four Alternatives to Venture Capital
Venture capital is not the right solution for every business. Sometimes the VCs are not interested in your idea, while other times founders are unwilling to accept the terms of the equity infusion. Here are four alternatives to venture capital.
With this method, the business is funded by the owners and their close friends and family. The founders run the business with as few employees as possible, with most wearing multiple hats. The goal is to achieve profitability as quickly as possible so that the business becomes self-funding before the money runs out.
Crowdfunding has gained popularity in recent years. On websites like Kickstarter and Indiegogo, people with ideas for a business or product can offer up their concept, then gauge the market with other users’ levels of support. These platforms accept pre-orders and other types of financial boosts from customers that help to fund the business.
Banks are hesitant to lend to startups and businesses that aren’t turning a profit. Many entrepreneurs have day jobs or equity in their homes, which make bank loans a stronger possibility. The Canada Small Business Financing Program may guarantee a portion of the small business loan, giving a bank more incentive to approve the application.
Direct Public Offering
A direct public offering means a company sells shares directly to the public. This option allows businesses to raise funds without involving an underwriter, which considerably lowers the costs of raising capital.
How to Prepare to Apply for Venture Capital
If your business is not taking off for reasons other than funding, throwing money at the problem will not make it better. Make sure that you are doing everything right in-house before you apply for venture capital.
Forget the elevator pitch. You may not have 60 seconds to pitch your idea. You need to be able to clearly describe your business in one or two sentences.
Have a catchy summary video and memo. It is said that a picture is worth a thousand words. Prepare a quick video that highlights the opportunity of your business. Have a memo that can accompany the video to pinpoint how your idea solves a problem for your target audience.
Pitch your business. Use this opportunity to expand upon your business idea with your slide deck. The slide deck is important, but this is primarily a way for the venture capital firms to get to know you, your team, and your story. The VCs will very quickly determine your credibility and future potential.
Always have an up-to-date business plan. A business plan is never set in stone. Your business is constantly evolving and your business plan should reflect that positive momentum. Met a new revenue threshold? Hired a key employee? Received a new patent? Signed a new contract? The current version of your business plan needs to reflect all of your latest accomplishments.
Be ready for the due diligence. Before one penny is ever invested, a VC firm will perform several rounds of due diligence. Be prepared: This process can take several months. They will ask a litany of questions and review contracts, financials, and bank statements many times over as they gain an understanding of your business.
How to Attract Venture Capital
There's a saying in Silicon Valley: "If you have to ask if your company can get venture capital, then it most likely cannot." Venture capital seeks out companies that are primed to take off, if only they had the right amount of cash in the bank.
Find VCs that invest in your industry and focus on them. Every VC firm has a target niche that they invest in. They may focus on specific industries, certain sized companies, geographic boundaries, or an ideal investment size. Or it could be any combination of these factors. Most venture capital firms clearly spell out their target investment profile on their websites. Before you contact them, save everyone's time by ensuring you fit that profile.
For example, Salesforce Ventures recently created the Canada Trailblazer Fund to help cloud-based startups in Canada. They invested $100 million in a venture capital fund focused on tech startups. Based on their geographic preference for this investment, if your business is focused on United States consumers, for example, this fund is likely not for you.
Approach VC firms one at a time. Venture capital is a small industry. Word will get around if you are sharing your proposal with anyone who will listen. Be selective. Scour your personal, educational, and professional networks to uncover any relationships you may have with the firm. Your best chance of being able to present is a warm introduction.
Personalize the message that you send to a venture capital firm. Nobody likes to receive a generic email or a templated message. This money can make or break your company. If you want it, you need to put in the effort.
What to Expect When You Accept Venture Capital
When a VC firm invests in your company, your business will never be the same. Get ready for just about everything to change.
Your ownership will be diluted.
Accepting VC money means giving up equity in your company. In order to increase the size of the pie, you must be willing to distribute some of the slices. The increase from pre-money valuation (before the VC invests) to the post-money valuation (after they invest) will determine how much stock the venture capital firm receives. These shares come from existing shareholders and are diluted in the process.
Venture capital has an opinion on how to run your business.
When you accept their money, the venture capital firm gets the right to an opinion about how your company operates. Usually, this is managed with one or more of your company’s board seats going to a representative of the venture capital firm.
This expertise can accelerate your company's growth. These professionals often have industry connections and knowledge that your business needs. Their insights can help you avoid mistakes and realize opportunities that an untrained eye may not notice.
Is Venture Capital Right for Your Business?
This decision — should your company try to get venture capital? — requires soul-searching and research. Venture capital can give your business the capital it needs for the next stage of growth. Equity investments are often a preferred way to grow without the debt burden of bank loans.
With proper preparation and a solid vetting process, your business will attract a venture capital partner that can help it grow to its next level. Just remember that not all cash is the same shade of green. Be sure to find capital that is best suited for your stage of growth and that provides the industry expertise that you need to succeed.