A one-stop guide to all things venture capital for the early entrepreneur.
Startup founders have access to a variety of funding avenues, such as using their savings and ‘bootstrapping’ the company themselves or opting for debt or equity forms of financing, depending on the stage they are at. Of these, venture capital is the fuel on which the mainstream startup industry runs.
Venture capital is a type of high-risk private equity investment made specifically in startups, with the aim of gaining equity stakes in potentially disruptive businesses and technologies. VCs later ‘exit’ these equity stakes through selling them in an acquisition or IPO, or after their value increases through subsequent funding rounds. This is all done to multiply VCs’ investment returns.
For the startup, venture capture is a means to fund and thereby unlock the possibility of exponential growth, and it empowers startups to partake in what is often a fiercely competitive landscape.
Understanding and accessing venture capital can be tricky for the new entrepreneur. It takes time and smart networking to break ice with investors. While seasoned entrepreneurs learn the rules of engagement with time, for those just starting off, it’s important to know just what you’re getting into, and what will be expected of you in return.
How venture capital works
The money that venture capital firms invest in startups is not their own. Capital is sourced from investment companies, corporations, wealthy individuals and pension funds that are looking to invest in startups and potentially reap exponential returns. They come on board as ‘limited partners’ or LPs.
Venture capital is accumulated in and deployed from funds. These investment vehicles can be for general investment purposes, but they are usually focused on specific industries, geographies, or company stages. The Lever China Fund by Lever VC, for instance, is a fund focused on Chinese companies in the alternative protein space, whereas AC Ventures’ ACV Capital III L.P. Fund is aimed at early stage Indonesian tech startups.
The fund is managed and run by a general partner. These investment experts raise capital from LPs, decide where to invest it, manage their portfolio of startups (sometimes holding board seats in these companies), and work toward a successful exit over the next few years. GPs claim a percentage value of the fund as management fees as well as a percentage of the returns generated by the fund (known as “carry”).
Here’s what the investment process typically looks like in a venture deal:
- Founders approach venture investors through networking events, virtual conferences, introductions, or even emails. If they strike a chord, the firm invites the founders to pitch.
- If the investor is interested in the pitch, a series of meetings follow where they go back and forth with the founders on the specifics of their company. Here, they’re trying to understand the company as deeply as possible, and also gauge the founders’ capability for growing a company.
- The investor will also start the due diligence process, where they evaluate internal factors such as business model, financials, and founder backgrounds, as well as external ones such as competition and industrial landscape.
- At some point during the due diligence process, when the investor is convinced that there’s an opportunity and would like to close in on it, they will send the founders a term sheet. The term sheet is a non-binding agreement outlining funding details, such as the funding amount (“ticket size”), valuation, and equity share. Some investors send it just after initial due diligence is complete, while some others may wait for a deeper study – this depends on the specific investor.
- If things look good so far, the investors and the founders will start negotiating contract terms until they reach a consensus and a deal is signed. Overall, the process typically takes a few months to complete.
- Additionally, since startups usually raise funding rounds with specific amounts in mind, venture investors usually invest in groups. In fact, one venture investor will rarely ever fund the entire round. The round is typically led by an investor who commits a chunk of the required funding. This lead investor is joined by co-investors who participate in the round for smaller stakes in the company.
Venture equity investors aim to achieve an exit by selling their shares after a few years of holding company stock. An exit usually takes place where the startup goes public, is acquired, or merges with another company. Venture investors can also sell their stake to other investors if they wish to do so.
Things to know about venture capital
Although venture capital can be equity or debt based, equity financing is the more popular of the two. It is also raised in several rounds, meaning a Series A fundraise of, say, US$100 million, can be raised across staggered tranches of funding. (Read our deep-dive into the different types and rounds of funding here.)
Startups mostly raise venture rounds early on in their lifecycle, where they have little to no revenue, or when they are poised for growth and need funding to make that happen. Late stage deals, such as Series D, Series E and onwards do take place, but at this point, profitability needs to become a priority for founders, as it’s only a matter of time before investors begin asking questions about how their money is being used. It’s key to note that venture investors have their LPs to answer to, who may want to know why their investments haven’t been making any returns.
Further, since investors and founders negotiate funding amounts in exchange for equity, the more venture rounds the startup raises, the more equity (and therefore, ownership and control) the founders have to give away.
However, it’s not necessary for founders to have a successful, profitable business in order to access funding. In most cases, venture capital funding can be obtained if the startup has a minimum viable product, a minimal amount of sales revenue, and evidence of the ability to scale the business – even if the company is operating at a loss. This is why venture capital is high on risk. There’s no sure way to tell if the startup being invested in will make it, or if the funds will sink.
Venture capital is a high-risk, high-reward game. The ratios differ for each venture investor, but all of them expect some numbers of their portfolio companies to fail, moderate returns from the rest, and a big win from at least one or two of their investments. The one or two big wins are usually expected to make up for the failures of the remaining startups and allow VCs and LPs to make incredible returns.
Additionally, venture capital investors often provide founders with resources such as advice and access to networks. A good investor will tend to have genuine interest in the success of the company, keeping an eye on exit opportunities while providing support mechanisms for the founders they fund. Of course, this is because the stakes are high, but some investors also bring a true passion for building successful companies to the table.
When to go for a venture capital round
The primary reason to go for venture capital financing is when a company has identified a massive growth opportunity, but needs funding and support to be able to tap into it.
Venture-backed companies aim to enter new markets quickly and scale at speed, something which is often only achievable with additional funding. The current trend is also to push for billion-dollar valuations and achieve unicorn status (although this is by no means a reliable measure of the success of the startup or the ability of its leadership team – see Luckin Coffee and Honestbee).
In addition to growth, venture investors also demand high returns (in business, this is only fair considering the risk ratio). Some suggest that they need 3X returns on their funding value for the investments to be worthwhile.
The pressure to deliver is clearly high. Venture investors are also more involved than other kinds of investors, leading to the feeling that they may be breathing down your neck during moments of pressure.
If you’re leaning toward running your company as a small business, or you want to retain the ownership of the company within the founding team, taking on debt or bootstrapping the company would make more sense. These are perfectly smart ways to build a valuable business and solve genuine problems for your target audience.
However, if you believe your company can do for your industry what Facebook did for social media, Uber did for transportation, or Airbnb did for hospitality, venture capital might be just the thing for you.
Header image by jcomp on Freepik