Tech startups and other companies with high growth potential that need capital but are unable to secure conventional financing often turn to venture capital. However, it’s important to note that this is not always the best option because it requires that the business owner give up equity in the business and sometimes control.
In this blog, we’ll define venture capital, including where it comes from and the advantages and disadvantages.
Defining Venture Capital
Venture capital is money that is invested in a small business by an established firm that specializes in finding promising young companies. The investment is typically made before the company has produced meaningful revenue.
Why Do Small Businesses Seek Venture Capital?
The primary reason that small business owners turn to venture capital is that they do not qualify for traditional funding. Companies that successfully secure venture capital have developed rapidly scalable tech, though any investment in an ambitious startup could be considered venture capital.
Whereas other forms of financing must be paid back with interest, venture capital funding is provided in exchange for equity in the company. This ensures that the venture capital firm earns a profit on its investment. In addition, they are often given a seat on the board, which allows them a say in the company’s direction.
Where Does it Come From?
The primary source of venture capital is a venture capital firm, which is comprised of professional investors that understand financing and how to build a successful company.
The money comes from various public and private sources, including pension funds, foundations, endowment funds, wealthy individuals, and corporations. In 2021, venture capital firms in the United States raised over $100 billion and invested over $300 billion.
Individuals who invest in venture capital funds are limited partners, while venture capitalists are general partners who manage the fund and work directly with the companies. General partners actively work with the founders and executives of the company to ensure the business is growing and making a profit.
In exchange for the funding, venture capitalists expect a return on their investment, usually as a stake in the company. The relationship between the parties is typically long-term. Instead of recouping their money immediately, venture capitalists usually work with the company for 5 to 10 years.
When the company goes public or is acquired, the venture capitalist typically sells their shares with the hope that they will get more back than they paid.
Examples of Venture Capital
As a business owner, before you approach a venture capitalist, you need to know what type of capital you need. There are several types of funding:
Seed Capital: investment required to carry out market research and form the company before launch, including administrative costs and the cost to create sample products
Startup/Early-Stage Capital: used to recruit key management, conduct research, and prepare product/service for launch. Once launched, can be used to increase sales and efficiency
Expansion/Late-Stage Capital: used to expand production and/or increase market efforts for new products. Also used to increase production capacity, ramp up marketing, and increase cash flow as the company grows
Bridge Financing: used to facilitate important milestones such as a merger or initial public offering
Advantages & Disadvantages of Venture Capital
Venture capital isn’t the only option for startups. There are others, such as bootstrapping, or self-funding. For entrepreneurs that do seek venture capital, there are advantages and disadvantages:
- Facilitate rapid growth
- Valuable guidance from professionals
- No obligations for repayment
- Loss of control
- Conflicts of interest
Is Venture Capital Right for Your Startup?
In the right circumstances, venture capital can be a great option. However, it’s important to understand that you do give up a portion of control and profits. One of the most important decisions a company’s founder/leadership will make is whether or not to seek out and accept venture capital. If you need help determining whether or not venture capital is appropriate for your company, contact WHW Capital today. We can go over your options and help you make the best decision.