The term “venture capital” or “VC” was only known in financial circles a few short decades ago. The internet booms of the 1990s and early 2000s changed all that. Today, most entrepreneurs know that, if they have the right idea, they may be able to get VC funds to help build their idea into a successful company — or to expand their fledgling company into a market leader.
Still, many people don’t fully understand what venture capital is or how it works. They just know it has something to do with funding all those major — and minor — tech companies that now dominate their digital lives.
How Venture Capital Works
In a nutshell, venture capital is cash (usually) invested in a company by a firm or individual in exchange for shares of the company.
Sounds simple, right?
Think of it this way: new companies are usually financed in the following ways:
- Owner-provided funds
- Bank loans or lines of credit
- Private loans from family or friends
In those cases, the loans are paid back or the owner recoups their investment from future profits. The debts are usually paid off in installments, with interest accruing based on the length of the loan.
Venture capital does not incur debt, because the investor has purchased a part of the company. They are “paid” when their shares increase in value, resulting in regular dividends, IPO valuations, or when the company is acquired by another entity.
The VC Process
Before a company seeks out an angel investor or VC firm like Arthur Trueger’s BCCI, they usually do a lot of research. Most venture capitalists focus on specific industries or narrow product fields that are in line with the personal experience of the investor or company. It wouldn’t do for a software company to seek out a VC that specializes in manufacturing, or vice versa.
Once a start-up has identified potential sources of venture capital, they will undergo a process that usually includes the following steps:
- Present Proposal — this will include providing a solid business plan, industry forecast, and answering questions from the VC
- Due Diligence — the VC will review the company’s financial records, management team, product line, and all operating documents. They will also research further into the market potential and other relevant factors.
- Investment — If the start-up passes scrutiny, the VC will provide cash in exchange for the company to expand to the next level. Each deal will be unique, depending on whether the VC is purchasing equity or debt, how much ownership will remain in the hands of the existing owners, and what responsibilities the company and VC will have to each other.
One of the selling points for many small companies of VC investment is the experience that comes with the capital. Since the investor is essentially becoming a partner in the business, they will likely serve on the board of directors and help guide the company in its growth and development. In some cases, angel investors or VC firms will place someone in the company as a manager or officer where they can have a daily impact on the success of the business.
At the very least, venture capitalists serve as mentors and advisers through the development of specific products, scaling of production, or help founders walk through the IPO or acquisition process. That advice, usually borne of years or even decades of experience in a specific industry and in building businesses in general, is vital to young companies which may be helmed by inexperienced leaders.
Venture capital investment is not the answer for most start-ups or companies seeking to expand quickly. This is why electronic and tech companies are the most popular recipients of VC funds. Even if a company fits that profile, the current owners, usually the founders, have to be willing to trade a part of their ownership for the capital. If they are not open to accepting advice and answering to long-term partners, VC isn’t for them.