Venture Capital: What It Is & Why Use It

What is venture capital?

Venture capital is financing that’s invested in startups and small businesses that are usually high risk, but also have the potential for exponential growth.

The goal of a venture capital investment is a very high return for the venture capital firm, usually in the form of an acquisition of the startup or an IPO.

Why would you want to use venture capital?

Venture capital is a great option for startups that are looking to scale big — and quickly. Because the investments are fairly large, your startup has to be prepared to take that money and grow.

Advantages of working with venture capitalist firms

The biggest advantage of working with venture capital firms is that if your startup goes under — as most do — you’re not on the hook for the money because unlike a loan, there’s no obligation to pay it back.

Venture capitalists come to the table with a lot of business and institutional knowledge. They’re also well-connected with other businesses that could help you and your startups, professionals that you might want to take on as employees, and — obviously — other investors.

Disadvantages of working with venture capitalist firms

While you don’t technically have to “pay back” venture capital, venture capital firms are expecting a return on their investment.

That means that a startup that accepts VC money needs to be planning for an exit of some kind, usually an acquisition or an IPO. If that’s not your goal — or if you see yourself running your startup forever — then venture capital is not for you.

On that note, part of what venture capitalists want in return for their investment is equity in a startup. That means that you give up part of their ownership when you bring on venture capital.

Depending on the deal, a VC may even end up with a majority share — more than 50 percent ownerships — of a startup. If that happens, you essentially lose management control of your company.

How does venture capital work?

A venture capital firm is usually run by a handful of partners who have raised a large sum of money from a group of limited partners (LPs) to invest on their behalf.

The LPs are typically large institutions, like a State Teachers Retirement System or a university who are using the services of the VC to help generate big returns on their money.

The partners have a window of 7 to 10 years with which to make investments, and more importantly, generate a big return. Creating a big return in such a short span of time means that VCs must invest in deals that have a giant outcome.

These big outcomes not only provide great returns to the fund, they also help cover the losses of the high number of failures that high risk investing attracts.

Venture capital firms make a small number of investments

Although venture capital firms have large sums of money, they typically invest that capital in a relatively small number of deals.

It’s not uncommon for a VC with $100 million of capital to manage less than 30 investments in the entire lifetime of their fund.

The reason for this is that once each investment is made, the partners must personally manage that investment for up to 10 years. While money is often plentiful, the VC’s time is very limited.

With such a small number of investments to make, VCs tend to be very selective in the type of deals they do, typically placing just a few bets each year.

Regardless, they still may see thousands of entrepreneurs in a given year, making the probability that an entrepreneur will be the lucky recipient of a big check pretty small.

The most common check written by a venture capital firm is around $5 million and is considered a "Series A" investment. It’s relatively uncommon for these checks to be the first capital into a startup.

Most startups begin with finding money from friends and family, then angel investors, and then a venture capital firm.

Depending on the size of the firm, VCs may write checks as little as $250,000 and as much as $100 million.

The smaller checks are typically the domain of angel investors, so VCs will only go into smaller sums when they feel there is a compelling reason to get in early at a startup company.

Favored industries for venture capital

Venture capitalists also tend to migrate toward certain industries or trends that are more likely to yield a big return. That’s why it’s common see so much venture capital and angel investment activity around technology companies: They have the potential to be a huge win.

VCs know that for every 20 investments they make, only one will likely be a huge win. A win for a VC is either one of two outcomes – the company they invested in goes public or is sold for a large amount.

VCs need these big returns because the other 19 investments they make may be a total loss. The problem, of course, is that the VCs have no idea which of the 20 investments will be a home run, so they have to bet on companies that all have the potential to be the next Google.

Conversely, other types of industries may yield great businesses, but not giant returns. A landscaping business, for example, may be wildly successful and profitable, but it’s not likely to generate the massive return on investment that a VC needs to make it’s fund work.

The other reason VCs tend to invest in a few industries is because that’s where their domain expertise is the strongest.

It would be difficult for anyone to make a multi-million dollar decision on a restaurant if all they have ever known were microchips. When it comes to big dollar investing, VCs tend to go with what they know.

Unlike a bank that takes all interested customers, VCs tend to be far more selective in who they take pitches from.

Often these relationships are based on other professionals in their network, such as angel investors who have made smaller investments in the company at an early stage, or entrepreneurs whom they may have funded in the past.

How do you get venture capital?

First step for getting venture capital? Getting in front of some venture capitalists.

General things to consider when you’re looking for a venture capital firm

VCs will expect entrepreneurs to be very buttoned up. They’re writing big checks to a small number of companies, so they have the luxury of only investing in the well-prepared businesses.

The first step to finding venture capital is to make a smart introduction to the venture capital firm you’re interested in meeting. Venture capitalists rely heavily on trusted connections to vet deals.

While some VCs will take pitches from an unsolicited source, it’s best bet to find an introduction through a credible reference.

You also shouldn’t try to contact as many people as possible. Instead, try to find venture capital firms that are the best possible fit for your startup and your deal.

The more closely aligned your startup and you, as founder, are with the needs of the venture firm, the more likely you’ll find venture capital firms willing to write you a check.

Every pitch to a venture capital firm starts with an introduction to someone at the firm. It helps to know the exact profile of a venture capitalist to know which level of introduction makes sense.

Typically it’s starts with an introduction to an associate and then you can work their way up to the full partnership.

But if you can’t find any connections? Your next best alternative is to make the warmest possible introduction.

You’re looking for any connection you can make to the venture capitalist so that you can demonstrate you’ve done your homework and you’re not just sending out form letters.

Look for any background you can find on what previous deals they may have done that relate to your pitch. Look for some recent press that they may have gotten that you can refer to.

You just need to create a little bit of warmth and personality to what is otherwise a cold intro. Showing that you’ve already done some of the homework will go a long way toward making sure you don’t wind up in the “deleted” folder.

And getting a commitment from a private investor relies on the strength of a founder’s pitch. But the pitch process starts long before a founder finds themselves standing in front of the investor with a pitch deck.

Luckily, most VC firms have a documented process founders should follow in order to guide their approach.

The elevator pitch for a venture capital firm

The first thing a founder needs to send to angel investors is an elevator pitch. The elevator pitch isn’t a sales pitch.

It’s a short, well-crafted explanation of the problem a startup solves, how they solve it, and how big of a market there is for that solution. That’s it.

You don’t need to “sell” the angel investor in the introduction. The opportunity should speak for itself.

For more information on email pitches, read “How to Create the Perfect Email Pitch.”

The pitch profile for a venture capital firm

These days, just about everything is done through email, which means just about everything is also available online.

Sending an elevator pitch along with a 20 megabyte PDF document is a surefire way to never even make it past an investor’s spam filters.

Instead, send a link to your pitch profile, which is an online profile that explains a little bit about the deal and provides a way for the investor request more information.

You can create a funding profile on Fundable.com. It only takes a little while and is an easier way to provide a reference back to a company profile than messing with attachments.

Investors may also ask for an executive summary but over the past decade, this has become less and less common, with most preferring a pitch deck. Regardless, it’s a good idea to have one prepared — just in case.

The executive summary is a two to three page synopsis of your business plan that covers things like the problem, solution, market size, competition, management team and financials of your startup.

It’s typically in narrative format and includes a paragraph or two about each section. You can expect the angel investor to jump to the one section they’re most concerned about, read a couple paragraphs, and then maybe look a little deeper.

They figure you’ll answer most of these questions in the pitch meeting, so they’re not going to spend too much time on the documents.

Pitch deck for venture capital firms

A pitch deck is essentially a business plan or executive summary spread across 10 to 20 slides in a PowerPoint document.

Here is a complete breakdown on how to create a pitch deck: Pitch Deck: Complete Guide to a Pitch Presentation

Investors like pitch decks because they force you, the founder, to be brief, and hopefully use visuals instead of an endless list of bullet points. The pitch deck is your friend and most trusted ally in the pitch process.

You’ll use it as your main collateral item to get meetings, it will be the focus point of your meetings, and it will be what investors peruse after meetings.

The pitch meeting for venture capital firms

Once the investor has reviewed the your materials and determined they are interested in meeting with you, the next step is to arrange a time for a pitch meeting.

In some cases — particularly with early stage investment — the pitch meeting is more about the investor liking you as a person than it is just pitching the idea. So take a little time to establish rapport.

Investors will more often invest in an entrepreneur they like with an idea they have some reservations about than an idea they like and an entrepreneur they think is a jerk.

During the pitch, you’ll run through their pitch deck and answer questions. The goal isn’t to get to the end of the pitch deck in 60 minutes or less.

The goal should be to find an aspect of the business that the investor actually cares about and zero in on that point. If the investor wants to spend 60 minutes talking about the first slide, you shouldn’t rush them.

There are no points awarded for presenting the 20th slide. Focus on the conversation.

The business plan for venture capital firms

Venture capital firms don’t actually read business plans, but they sure are glad when founders have one. Business plans aren’t really about the document itself — they’re about the planning that goes into composing the document.

It’s highly unlikely that you’re are going to get asked to submit a full business plan to a venture capital firm, but it is likely that you’ll be asked all of the hard questions that could be answered in the business plan, so putting one together is a perfect way to prep for your meeting.

Luckily, we have Bizplan’s business planning software to help you with this step.

The financials for venture capital firms

Of all the documents that you’re going to be expected to be armed with, the financials are the most important.

Most venture capital firms are going to expect a reasonable four-year projection of the income and expenses of the business.

They’ll want to know how quickly you’ll be able to get the business to break even.

They’ll want to know what you’re intend to use their money for.

And, of course, they’ll want to know how you intend to get their investment back to them — with a healthy return.

You should be prepared to provide an income statement, use of proceeds, and breakeven analysis at the very least.

Due diligence for venture capital firms

The last item is kind of a catch-all that we’ll call “due diligence.”

When the venture capital firm gets more interested in a deal, the next phase of discovery is called due diligence. During this phase, they’ll dig into all the details of the business, from financials to the details of how the business model works.

This is where all of the research and support you’ve put together will be put to the test. They’re likely going to ask you to prove how you arrived at the market size they’re going after.

You may get asked to have your early customers talk to the venture capital firm. Assume the firm is going to do its best to make sure everything you said actually checks out.

What types of venture capital are there?

The different types of venture capital are based on the stage the startup is in.

1. Early stage funding

Early stage funding includes seed funding and Series A.

The very first money that many enterprises raise — whether they go on to raise a Series A or not — is seed funding. (Some startups may raise pre-seed funding in order to get them to the point where they can raise a traditional seed round, but not every company does that.)

The name is pretty self explanatory: This is the seed that will (hopefully) grow the company. Seed funding is used to take a startup from idea to the first steps, such as product development or market research.

Once a startup makes it through the seed stage and they have some kind of traction — whether it’s number of users, revenue, views, or whatever other key performance indicator (KPI) they’ve set themselves — and they’re ready to raise a Series A round to help lift them to the next level.

In a Series A round, startups are expected to have a plan for developing a business model, even if they haven’t proven it yet. They’re also expected to use the money raised to increase revenue.

Because the investment is higher than the seed round— usually $2 million to $15 million — investors are going to want more substance than they required for the seed funding, before they commit.

It’s no longer acceptable to have a great idea — the founder has to be able to prove that the great idea will make a great company. The typical valuation for a company raising a Series A is $10 million to $15 million.

2. Expansion funding

Expansion funding includes Series B and Series C.

Companies that make it to the Series C stage of funding are doing very well and are ready to expand to new markets, acquire other businesses, or develop new products.

Commonly, Series C companies are looking to take their product out of their home country and reach an international market. They may also be looking to increase their valuation before going for an Initial Public Offering (IPO) or an acquisition.

For their Series C, startups typically raise an average of $26 million. Valuation of Series C companies often falls between $100 million and $120 million, although it’s possible for companies to be worth much more, especially with the recent explosion of “unicorn” startups.

Valuation at this stage is based not on hopes and expectations, but hard data points. How many customers does the company have? What’s it’s revenue? What’s it’s current and expected growth?

Series C funding typically comes from venture capital firms that invest in late-stage startups, private equity firms, banks, and even hedge funds.

Other financing options

While venture capital can be a great option for startups, there are a lot of other financing options available. If you’re looking for other ways to raise money for your startup, don’t miss our other guides:

1. Series Seed Funding: A, B, C, D, E
2. Crowdfunding
3. Small Business Loans
4. Small Business Grants
5. Private Investors
6. Angel Investors
7. Stay tuned for future guides!