Definition of venture capital
Venture capital (VC) is finance provided to start-ups and small-to-medium enterprises that are seen to have high growth potential that exceeds that of most businesses. Venture capital investors usually are high net worth individuals, venture capital firms, investment banks or a range of other financial institutions. In exchange for taking the risk investing in early-stage companies, they expect a high return. This can be achieved by selling the business privately, merging with another company or going public through an initial public offering (IPO).
How venture capital works
With venture capital, you create and sell pieces of the company to investors through partnerships established by venture capital companies. Venture capital usually applies to emerging companies that are seeking a large amount of funds for the first time. This is in contrast to private equity investments which fund larger established businesses that are seeking equity finance.
Funds are often provided by angel investors, who are wealthy investors who have started successful businesses and are seeking to invest in an emerging business, act as a mentor and advisor, and get a return on their investment. Learn more about angel investors.
How to get it
You will want to determine whether you have the type of business that is appealing for this type of finance. Investors are looking for businesses that have a high growth potential and offer an innovative product or service. Many VC investments are made into businesses such as software, life sciences medical/healthcare and biotechnology.
If you are in an industry that’s attractive to VC investors, you will need to create a compelling business plan and submit it. An effective business plan will include an explanation of your business model; the product or service you are offering; the size and potential of the market; financial projects; and profiles of the management team. To learn more about creating a business plan, visit How to Write a Business Plan.
If the VC investors are interested in your business plan, the next step is to have a meeting to discuss the business in detail. If the investor decides to move forward after reading the business plan and discussing in a meeting, the next stage of the process is for them to conduct due diligence.
Before making a venture capital investment, the due diligence stage is used for making sure all the information provided is correct and realistically represents the opportunity. The process usually includes interviewing customers and management to confirm what has been presented in other formats.
If the venture capital investors are satisfied with the outcome of the due diligence, they will create a term sheet outlining the terms and conditions of the investment. The term sheet is not binding and subject to negotiation. Once the terms are agreed upon by all parties, legal documents are signed and the initial investment is released.
Learn more about term sheets.
Pros of venture capital
For the right type of business, venture capital can be a good way to raise capital. Here are a few pros of venture capital:
- The new business can get substantial finance which would not be possible with other sources.
- The venture capitalist can play an active management role, offering expertise and advice based on experience running successful businesses.
- You don’t need to repay the money as it’s an investment in your business and not debt.
- You could get a substantial amount of money in the long-run if the business is sold or has a successful initial public offering (IPO).
Cons of venture capital
- You won’t have total control of the business because the venture partners will become co-owners who are involved in management and decision making.
- VC investors invest in companies that have an exit strategy, such as selling or merging the business, so you might not be involved in the long run management of the company.
- There are no guarantees that you will get the money when you seek venture capital.
- It’s a long-term proposition, so it’s won’t help if you need quick funding for your business.
Next steps if you are seeking venture capital
Unlike bank loans, much of venture capital funding occurs through formal and informal networks. Through social media, entrepreneurs and investors can connect on platforms such as LinkedIn and Facebook. There are also MeetUp groups that are focused on networking between business owners and investors. One example in Australia is the Angel Investment Network.
Before making the effort to connect with potential investors, you will want to complete a business plan that clearly explains the opportunity you are promoting.
If you are at an earlier stage of development, there are various forms of business loans to consider, including unsecured business loans. Also check out our business loan calculator to get an estimate of principal and interest repayments for business loans.