Venture capital is a type of financing provided to privately-held businesses by investors in exchange for partial ownership of the company.
Venture capitalists (VCs) are more often firms, such as Kleiner Perkins or Sequoia. But individuals who are VCs are more generally known as “angel investors,” because they often get involved earlier and take a smaller stake.
VCs identify promising new technology, products, or concepts, and then provide the funding needed to move the project forward. As payment for their investment, they typically take an equity, or ownership, stake. While the impression may be that VC funding is pretty typical, in fact, historically, fewer than 1% of companies have landed VC money. It’s the exception, not the rule, according to the Harvard Business Review.
Equity financing basics
Equity financing involves selling an ownership stake in the company in order to get funding without the need to pay it back. Debt financing involves borrowing against the business, with a promise to repay whatever amount was borrowed, plus interest. The advantage of debt financing is that companies do not give up any ownership or control. However, debt financing is extremely difficult for early-stage businesses to obtain, since traditional financing sources, like banks, want to see revenue, and assets, and collateral, which few young businesses have.
The difference between VCs and banks
The key differences are:
- VCs invest in young, early-stage, aggressive-growth companies where banks will only lend to more established, profitable ventures.
- VCs take an equity position, meaning ownership with no repayment of funds, where banks lend money that needs to be repaid.
- VCs look for businesses where the risk-reward ratio is large where banks want no part of risk. At all.
- VCs aim for exponential growth within 4-6 years where banks want to be repaid in 7-20, depending on what the money is being used for.
- VCs are active investors, often becoming involved in the management of the ventures they invest in, while banks are passive and stay on the sidelines.
But VCs offer more than a cash infusion. Many VCs want to have a positive impact on the growth trajectory of the businesses they invest in. They don’t just want to hand over money and watch the company take off. No, they want to play a role in helping the company be as successful as possible. That means requiring a seat on the board of directors or assuming a consulting role within the business.
It’s rare that a VC firm or angel investor will stumble across a new opportunity. It’s more typical that a young venture will seek out VCs. That can happen through:
- Participation in a business accelerator or incubator
- A meeting with a VC firm
- An official pitch event
Attracting VCs will require a pitch deck, which is a PowerPoint presentation about the technology or concept in development. If interested, VCs will next want to see a comprehensive business plan explaining how the company will make money, and when. Due diligence is the next step in the process, when VCs research and triple check all the assumptions and statements made in the business plan. If they like what they see and hear, they may offer a term sheet outlining what they are willing to offer in terms of an investment and under what conditions.
What’s typically appealing about VC funding is the caché of being associated with a well-known firm, the guidance offered by veteran entrepreneurs, and the infusion of cash without the need to pay it back. The downsides are the loss of control, the loss of ownership, and the pressure to rapidly ramp up sales and profits to meet VC expectations.