Venture Capital
Investors provide capital into an early-stage business with high growth potential in exchange for an ownership share.
Venture Capital (VC) is a type of investment designed to fund high-risk investments in early-stage companies that demonstrate high-growth potential. Venture capitalists invest money from high-net-worth individuals and families, pension funds, and university endowments so that their portfolios can grow larger by taking risks.
Venture capital vs. small business funding
Venture capital is not the only type of capital available to early-stage companies, and only funded 0.05% of startup companies in 2019. Venture Capital is not designed to fund small businesses with local aspirations. Loans, grants, and emerging alternative forms of capital target small businesses.
Venture capital vs. impact venture capital
An emerging subset of venture capital invests in companies that promise to address social or environmental challenges or who intend to be measured by Sustainable Development Goals. Within an investment continuum of expected returns, impact investing runs the gamut from below-market returns and exponential growth depending on the specific complex problem and the social, technical, and cultural change required to achieve the intended goal.
This post focuses on normative venture capital – capital firms that invest in early-stage growth companies that may or may not address an issue. VC has been traditionally concentrated in Silicon Valley and focused on funding technology and software companies that scale exponentially.
Example Firms
Andreeson Horowitz | Benchmark Capital | Kleiner Perkins | Union Square Ventures
Is Venture Capital finance the right capital for your business at this stage?
COMPANY PERSPECTIVE
Benefits
- Funds risky bets
- No assets required - no collateral needed
- The business has no obligation to repay investment capital
Challenges
- Founders give up ownership share over time and often lose majority control
- Investors expect an exit - either an IPO, direct listing, or acquisition and will steer directions to achieve high returns
- Very few companies that seek venture capital receive venture capital
Key Performance Indicators
- Pre-money valuation
- Post-money valuation
CAPITAL GIVER PERSPECTIVE
Benefits
- Support founders growing innovative companies
- Best bets generate highly lucrative returns
- Need only 1/10 to deliver breakthrough outcomes to be successful
Challenges
- Often review 1000 deals to make 1 investment
- Deal pricing for "hot" companies makes it difficult for investors to see a return
- Many venture capital firms do not return value to their investors above public market-rate returns
Key Performance Indicators
- Internal rate of return (IRR)
- Net present value (NPV)
When it Works Well
High-risk high-reward
Investors in venture capital funds include high-net-worth individuals and their money managers, called family offices, and institutional investors, such as pension funds. These money managers seek to invest a small percentage of their portfolio in high-risk high-return assets. Their investments work well when they pick the highest-performing funds that deliver an outsized return.
Fits VC investment thesis
Venture capital firms do not fund all types of companies. Each VC firm has an investment thesis that describes what they believe about sector and technology change that helps guide their investments.
VCs do not typically invest in technology that requires multiple years of R&D, nor are they primed to address major social issues outside of the narrow band of technology solutions they prefer. VCs focus on solutions that have high rates of growth, and that have the potential to command a major share of the industry.
You fit the VC’s desired stage
VCs typically do not, therefore “write the first check,” but wait for companies to test product-market fit with the backing of angels, seed investors, and accelerators. VCs are primed to invest when an early-stage company proves that they’ve found a repeatable pain point and they have a go-to-market strategy with evidence of customer demand, also known as traction.
The bulk of venture capital in dollar amounts is invested in later-stage funds. Be aware that venture firms tend to focus on stage. Smaller funds invest in the seed round or “A” early-stage rounds. Mezzanine funds tend to invest in Series B, C, or D designed for scaling up operations. Later stage funds include pension funds themselves that invest in the rounds leading up to acquisition or initial public offering.
Helps survive hyper-competitive sector
Why are VCs willing to fund companies that operate at a significant loss? Successful VC partners believe that taking risks to be the winner in a market is the only way to generate superior returns. High-scale businesses require significant capital to quickly accelerate to the point where they can win in a competitive market. A substantial influx of capital can create the conditions to survive in the short term in order to endure and thrive in the long term.
Eyes on an exit
For founders and company owners who see to grow a company and then “exit” or sell the company, then aligning to a well-connected venture capital firm helps to facilitate those later-stage investments and transactions. Similarly, company managers who plan an IPO or initial public offering benefit from firms with strong relationships with investment banks that work in the public markets.
Challenges to Venture Capital Finance
Most VCs underperform
A less well-known reality is that most venture capitalists underperform – they do not return expected value to their limited partner shareholders. VCs are expected to take risks and deliver higher-than-market-rate returns. During the last several years, however, it has been hard to both out-compete the public market performance, especially for tech giants like Apple, Amazon, and Tesla.
Yet many VC firms, fail to generate these above-average returns. Meanwhile, their investors sign multi-year agreements to fund the firm, and the VC firm often charges a 2% management fee per year (a $100 MM firm charges $2 MM per year to run the firm). VC is a growing asset class because it is one of the only ways to invest in technology companies that have come to shape the overall market.
Terrible diversity track record
One of the most alarming aspects of venture capital is the percentage of funds that are invested in white male founders.
Only a small percentage goes to women-only founding teams (less than 8%).
For Black, LatinX, or Indigenous founders the amount of capital invested is less than 0.05%.
During the 2020-2021 time frame increased awareness of diversity practices and outcomes in all industries, Venture Capital funds reversed previous improvements and ended up decreasing amounts of investment capital to women, Black, LatinX, and Indigenous founders.
Too much press
Venture capitalists benefit from attracting a great deal of press for their individual careers and funds, and because they invest in new media companies they tend to generate outsized interest in their activities. As a result, the general business public believes that Venture Capital is the only type of entrepreneurial capital, and the type of advice spouted by these funds shapes public policy, grant-giving, and university tech incubation structures.
VCs invest in only 0.05% of all startups in the US, and even less in other countries. They are a unique asset class designed to power high-growth, high-return outcomes and it is not for all types of entrepreneurial pursuits.
Founder-investor conflict
VC is structured to support market-dominating winners, so when the going gets tough for the less performing firms undergo wrenching changes. The founding management team may be forced out, or the firm may undergo a down-round (newer investment lowers the value of the firm overall). The company may be forced to “exit” or be acquired prematurely because a lead venture owner is trying to finalize their own fund and clean up the less performing companies in their portfolio.
If the company was able to reach steady-state growth, rather than 10x or more fast growth, there often is no option to buy out the funders and manage the business because of the underlying value that was agreed to in key fundraising documents.
Limits to VC board influence
Venture Capitalists tend to serve in powerful board roles in the companies that they fund and can have an outsized influence on the direction of a company. In 2017 VCs intervened to encourage Travis Kalanick, the founder of Uber, to resign after controversy over the company’s reported unethical culture, including allegations that he ignored reports of sexual harassment at the company. At the same time, the VC board members of Facebook have been criticized for failing to adequately steer the founder to adopt more ethical data practices.
Trends in Venture Capital Finance
Providing operational support
Andreeson Horowitz, a venture fund founded by former entrepreneurs, invests much of their management fee in providing services to its portfolio companies, from design to sales and marketing support to public relations. Several VC firms have adopted this structure but most remain more hands-off, providing lightweight support in the form of network introductions and board meeting participation.
Rise in global Hubs
COVID19 has accelerated a trend already underway: the emergence of Beijing and Shanghai as power centers in VC, while Boston and New York continue to vie for 2nd and 3rd place in the US. VCs have been more willing to accept virtual pitch meetings from all over the world, and the rise of purely distributed teams (with no fixed headquarters) has changed the playing field for who fits the criteria for these firms, who used to insist on in-person pitch meetings and local investment.
Alternatives to VC
VC does not fit the capital requirements for most entrepreneurs, especially those that do not want to lose ownership control of their company, or who do not want to align to an exit strategy at the start. Alternatives to venture capital have been created to fit this growing need particularly focused on entrepreneurs who are growing steady-state businesses or who seek to keep wealth within communities.
Before You Consider Venture Capital Finance
- Do you have a strategy for growing quickly?
- Do you already have evidence of customer demand?
- Are you ok with losing ownership control of your company in exchange for a tight timeline to exit the company?
- Do you have an exit strategy (likely firms that may acquire your firm or a clear path to an initial public offering)?
Exploring Venture Capital Finance
- Many venture capitalists are active on Twitter and on podcasts – participate in or observe their public conversations.
- A well-run fundraising effort may involve reaching out to 100 investors in order to get one favorable term sheet, or investment agreement. Start your research early to find like-minded funds.
- If you have received an inquiry from an investor but you were not in the market for funds, make sure to do due diligence on the investor. Ask to speak to both successful and unsuccessful companies in their portfolio.
- Make sure you determine whether your VC is a high performing or low performing investor.
Discover Alternative Capital
Venture Capital is one way to grow your company, and you can choose other capital types as an alternative or pair and combine at different stages of your business. Consider these alternative capital sources or explore our Capital Library.
