A major barrier for entrepreneurs is often funding. However, if your startup has high growth potential, an option could be to use venture capital. Even though investing in a startup incurs significant risk, venture capitalists are often willing to take a leap of faith if they think a startup could be the next big success.
How Does Venture Capital Help Startups?
First, though, what does a venture capitalist do? What is the role of a venture capitalist and how could partnering with one help your startup?
Simply put, venture capitalists provide startups with private equity. Most venture capitalists are limited partnerships made up of a group of people who invest the venture capital fund in promising companies. Each fund also has a committee that makes decisions about investments.
Venture capitalists rarely decide to invest in startups that are only recently established. Typically, they wait until the startup is ready to go to market with an idea. They then provide capital to allow the startup to promote and sell its offering and continue to grow. However, you may not receive the full amount at the beginning — the venture capitalist may prefer release funds over a period of time.
In exchange for funding, the venture capitalist will have a stake in your company. This means the firm will have an input in how you run your business. You should also note that venture capital tends to be a short-term investment: after a few years, the investor usually sells the equity or exits through an initial public offering.
How Much Do Venture Capitalists Make?
A study of 105 tech companies looked at venture capital ownership when the companies went public. The study found that the median level of ownership was 53 percent and the average level was 50 percent. However, the median level of ownership was just 44 percent and average level 42 percent for e-commerce and hardware companies. This means you can expect a venture capitalist to own about half your startup, although this could be less if you have the type of business that is likely to generate cash.
All this is useful to know for two reasons. First, it can help you decide if you want to pursue venture capital at all. Second, you can use the median and average levels as benchmarks to decide if a venture capitalist is requesting a reasonable level of ownership.
How Do Venture Capitalists Evaluate Startups?
Of course, venture capitalists won’t just provide funding for any startup that asks. The huge number of opportunities allow investors to be as selective as they like. Knowing what venture capitalists look for in a startup will help you frame your company as a good option and increase the chances you do receive funding.
1. Experienced Managers
The most important factor for a venture capitalist is the management of the startup. You are more likely to receive funding if you have launched a successful venture in the past — or if you at least have executive experience.
2. Low Risk
There is always risk when investing in a startup — and venture capitalists want to see the lowest risk possible. There may be demand for your offerings now, but will there still be several years down the road? Venture capitalists are also looking for startups that are unlikely to face regulatory or other legal problems. Finally, the amount the venture capitalist is willing to invest must be sufficient to bring your project to fruition.
3. Large Market
Lean startups often target small markets for the opportunity to grow without high expenses. This is great if you’re funding the startup yourself, but it’s unappealing for venture capitalists. In fact, the larger your target market, the more likely you are to receive funding.
Investors want to see that you have something unique to offer. A product or service that is just a slight twist on something that already exists is unlikely to receive venture capital. You need to create a solution to a problem that no one has been able to solve before.
When Shouldn’t You Seek Venture Capital?
There are both pros and cons of using venture capital. In some situations, venture capital may not be the way to go.
You Haven’t Invested in Your Startup Yourself
Venture capital should not be an alternative to your own investment. Instead, it should supplement what you can afford to invest. Only when you’re financially invested in the startup will you put in the full effort it takes to give your venture the greatest chance of success.
You Haven’t Asked Others for Money
In addition to your own money, you should be asking people who you know to help you fund your startup for the same reason as above. After all, the last thing you want is to lose money from those close to you. Only once you’ve exhausted these options should you turn to venture capital.
Returns Are Likely to Be Low
No one will be interested in investing anything in your startup unless you can guarantee decent returns. Only start searching for venture capital if you have a high degree of certainty that it will be worthwhile for the investor.
Your Startup Urgently Needs Capital
If you’re seeking venture capital because you have no idea how to keep your startup afloat otherwise, funding is not the answer. A better option may be to pivot.
What Are the Consequences of a Failed Startup for Venture Capitalists?
The fact is that some startups (actually, the vast majority) do fail. If your startup fails after you’ve received venture capital, what will happen?
If you took on debt in your name, you will be responsible for paying the debt back. However, if you’ve established your startup as a separate legal entity (such as by forming a limited liability company), your startup holds the debt and you are not liable for anything personally. All the same, you will need to try to pay off as much of the debt as possible. This will enable you to pay back venture capitalists some of the funds they contributed — although they’ll likely still face some loss.
Bear in mind, though, that the venture capitalists own part of your startup and may decide that closing the business is not the best course of action. They may prefer to file Chapter 11 bankruptcy and continue running the business. They may want someone new to take over management or they could decide to pivot.
You should also note that, whatever happens, the process will be long and drawn out when you’ve taken funds from venture capitalists. The investors may want to keep the startup running even though it is losing money, incurring more debt or adding more capital. Even if the venture capitalists decide to close your business, you’ll need to go through the proper procedure, which will involve everyone who has a stake in the startup plus lawyers.
How to Find Venture Capitalists for Your Startup
Should you decide venture capital is the way to go for your startup, you’ll need to reach out to venture capitalists who may be interested.
1. Seek Referrals
Few venture capitalists will even listen to a pitch unless you’ve been referred to them. It’s best to know at least an associate at the firm. You can use this person to get your foot in the door and receive an introduction to a partner.
2. Ask the Right Questions
When a venture capitalist does show interest, don’t be afraid to ask your own questions to make sure the firm is the right option for you. Some questions to ask a venture capitalist include:
- What other startups have you provided capital to? You don’t want anyone who has funded a competitor, but it may be a good sign if the venture capitalist has invested in other companies in your industry.
- What stage of funding do you usually provide? Seed is for early funding, Series A is for when you have established a product, and Series B is for when you are looking to expand. By Series C, the company has likely progressed beyond the startup stage.
- How long do you intend to stay invested? It is useful to know if the venture capitalist would be interested in staying with you for the long haul or is likely to exit early. As well as asking this question, you can research what the firm has done with other startups.
3. Find an Investor Who Shares Your Values
Whereas it may be true that applying to every venture capitalist you can find will increase your chances of landing an investment, this is a huge waste of time. A better approach is to search for a firm that shares your values, as such venture capitalists are more likely to be enthusiastic about your startup.
Beyond Venture Capital
Funding is just one of many considerations when running a startup. Another is talent. Even if you do decide to go down the venture capital route and receive a large investment, hiring a team is likely to be a waste of money. A better use of your capital is to outsource most of the main business functions that you don’t want to carry out yourself.
A great way to find talent for a wide range of roles is to use virtual assistants. The virtual assistants for entrepreneurs at MYVA360 are available whenever you need them and for whatever you need. Our VAs can increase the chances your venture succeeds.
Another way we can support your startup to see success is by helping you avoid some of the most common mistakes entrepreneurs make. Check out our infographic: Top 10 Reasons Why Startups Fail. Download it now for free.