A Beginner’s Guide to Venture Capital
You won’t hear many people describe finance as exciting. It’s mostly filling in spreadsheets with little more than guesses and then copying the guesses onto slideshows. If you want to make finance exciting, you have to talk about venture capital (VC).
When I spent five figures getting a Masters in Finance degree, the best part was the unpaid internship I had at a VC. I spent many nights working for free on deals just because I wanted to and more nights than I’d like to admit doing time value of money homework for the 27th time.
What is venture capital?
Venture capital, or startup capital, is the funding of young, fast-growing businesses. This doesn’t mean you can get venture capital for that closet manufacturing franchise you want to buy.
Venture capitalists are looking for returns of at least 100% per year with each investment and investments usually amount to $1 million or more. This means the run of the mill small business looking to expand into a second location or buy some equipment won’t be in the ballpark of VC funding.
And that’s fine, because VCs take a lot of equity -- you’re probably better off avoiding it unless your business can reach hundreds of millions in sales.
There are niche VCs, but generally, VCs will focus on technology (including software, online businesses, and traditional technology) and medical device/biotechnology business ventures. This is where the fast growth is, both in the individual company and in the market it’s addressing.
The 4 types of venture capital
If you’re building the next great Software as a Service (SaaS) product, which will revolutionize the millennial dog sitter-scheduling industry, here are the phases you will go through in the life cycle of startup funding.
Friends & Family
Unless you are independently wealthy when you start working on your startup, it always starts with friends and family. That uncle who got lucky with some oil well investments or your college roommate who invested in Bitcoin in 2010.
Friends and family will be the most empathetic to your cause. It sounds harsh, but they may look at the ‘investment opportunity’ as a way to help you more than a way to make money. Every other source on this list is trying to make money.
I’ve worked on many startup loans at a few different banks. Even with the backing of the Small Business Administration (SBA), startups are usually simply too risky for bank loans.
If you’ve produced impeccable projected financials, have a rich history of experience in the industry, clients lined up, and a professional-looking business plan, you may get $150,000 of working capital. As long as you’re OK with the bank taking a second lien on your house.
Angels are the professional version of friends and family -- so-called because they swoop in and save floundering startups with an investment like an angel.
If you’ve seen the show Shark Tank, those are angel Investors. They usually have long experience in business and can often offer consulting help as well.
Angels can offer both capital investment (cash in exchange for ownership in the company) and venture debt. Venture debt usually has rates in the teens to high teens and often comes with a conversion feature that allows the investor to convert their investment to equity.
Private Equity Funds
Venture capital funds are a subset of the wider universe of private equity funds. Private equity funds exist when partners pool their money to make investments in non-public (public meaning the stock market) businesses or other alternative investments.
Venture capital is the last step. Once you have an established product and are seeing significant growth, you may catch the interest of a venture capital fund.
How venture capital works
Here are the five key aspects that VCs will evaluate when making an investment.
Management is the most important item in a VC evaluation. Successful startup founders who have never attempted to start a business before, have no industry experience, and, frankly, aren’t willing to put in 100-hour work weeks, are few.
VCs are looking for visionary management teams that can do the job and delegate when needed.
2. Market size and market share
When I started my internship, I expected to spend hours building financials models and musing on the efficacy of business models. And that definitely happened. I also spent a lot more time than I expected doing things like walking around random sporting goods stores taking notes on end caps to calculate addressable markets.
If the business does not have a massive addressable market, it cannot become a massive business.
3. Product edge
Even if you have a great management team and a huge market you’ll be selling to, you still need a great product. VCs won’t be investing in anything that could be called generic. They prefer the proprietary.
When I worked in a box factory over a summer, I worked with a company that made a new machine that made custom size boxes. Businesses would purchase the machine and then fan-folded corrugated paper to feed into it to be turned into whatever size box they needed.
This is the type of thing VCs are looking for. That product saves all its customers money and has a clear positive impact on the environment. Even better, at least when I worked with it, the company had no discernible competition for making custom boxes.
4. Financial Projections
Given that venture capital is a financial business, you’d think financial projections would be the most important thing to VCs. In reality, they look at financial projections and projected business metrics with several shakers worth of salt. Management projections are typically discounted by at least 15% and sometimes much more.
Generally, VCs will determine the addressable market, make a guess what percent share your company can get, and then slap some cost projections onto it to do financial projections. These numbers will be accurate basically never. It’s more about getting a sense of what’s possible than trying to be accurate.
Valuation is derived from the financial projections, so is looked at with the same skepticism. Valuation is used to get a sense of what the potential rate of return could be with the business and to argue what percent of equity in the company the investment should garner.
The 4 stages of venture capital financing
Let’s consider the stages your business will go through with venture capital financing.
The concept phase is when you think of the product and then go to work. You write a business plan, learn about business ownership and startup accounting, reach out to vendors, and potentially even hire a few employees.
The seed stage is when you will launch your product. If you have a long history of successful businesses you may be able to fund the seed stage with venture capital. Otherwise, you will need to use one of the other sources listed above.
An alternative source of funding that became popular with the 2011 publishing of The Lean Startup by Eric Reis is to fund your product with customers. Build out the minimum viable product (MVP) and sell that to interested customers and then grow into better iterations as you make more money. Startups that can grow in this manner have a leg up for raising outside capital.
You’ll probably go through several venture capital rounds to raise money for growth. Each will have its own benchmarks, valuations, and probably, investors. Each successive round gives new investors less bang for their buck as far as equity goes.
Initial Public Offering
The final stage and the goal of most initial VC investments is the initial public offering (IPO). You’ll hire an investment bank to underwrite the offering and then go on a potentially worldwide roadshow pitching your company to the first investors who will buy the stock on the public market.
This is the stage when most private investors, including any angels you found, and VC funds will sell their shares. Often, the company has gotten so big that founders will sell shares simply to pay the tax bill on their gains.
Most businesses won’t ever come close to venture capital financing and those that do will likely either become spectacularly successful or fail spectacularly. If you want to go the venture capital route, know the basics of financing and then put the rest of your energy into your business. It’s going to need it.
Alert: highest cash back card we've seen now has 0% intro APR until 2024
If you're using the wrong credit or debit card, it could be costing you serious money. Our experts love this top pick, which features a 0% intro APR until 2024, an insane cash back rate of up to 5%, and all somehow for no annual fee.
In fact, this card is so good that our experts even use it personally. Click here to read our full review for free and apply in just 2 minutes.
Our Research Expert
We're firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.