Fundraising

A Guide to How Venture Capital Works

A short venture capital introduction could simply define this sort of funding as private equity for startups and small businesses. Investors generally understand that any explanation of a venture capital meaning should also include taking…

A short venture capital introduction could simply define this sort of funding as private equity for startups and small businesses. Investors generally understand that any explanation of a venture capital meaning should also include taking a relatively high risk in exchange for the promise of exceptional growth.  On the other side, owners sometimes have to give up some control and a stake in their company in exchange for financing.

To better understand the topic, find out more about kinds of venture capital funding, when it’s used, potential benefits and pitfalls, the history of this kind of private equity, and of course, what it’s like to work for a venture-backed business.

Venture Capital Financing

To better understand venture capital financing, it will help to learn about various kinds of venture funding, when they’re most desirable, and of course, some advantages and disadvantages of using venture capital.

Types of Venture Capital

Typical explanations of the types of venture capital divide it into three main groups, based upon the business stage that needs funding. This list provides a brief explanation of these venture capital types and the various business stages that they may apply to:

  • Early-stage: This might include seed financing, which is usually just a small amount of capital that will help the founders qualify for other loans. True startup financing provides enough capital to finish a service’s or product’s development. In contrast, startups might also get first-stage financing after the have finished development and need more funds to begin operating as a full-scale business.
  • Expansion: This kind of venture capital helps smaller companies expand significantly. For instance, a thriving restaurant may decide it’s time to open more locations in nearby communities. Sometimes, it also comes in the form of a bridge loan for businesses that want to offer an IPO.
  • Acquisition: Sometimes called buyout financing, this type of funding may help acquire other businesses or sometimes, just parts of them. For instance, some groups may use acquisition financing to buy into a particular product or concept, rather than using it for buying the entire company.

Pros and Cons of Venture Financing for Startups and Small Businesses

On the startup side, company founders may need this kind of private funding when they can’t access enough funding through bank loans, their own pocketbooks, and other traditional finance sources. The downside is that the company’s owners need to give up some equity and control to the investors. Thus, it’s important to find investors who will take the gamble and can align with the founder’s vision.

Of course, some of these investors may also bring experience to the table, which some founders may find gives them an advantage. It’s a good time to note that venture capital doesn’t always only come in the form or monetary financing. Sometimes, at least part of the capital could come in the form of expertise, equipment, or property. In fact, adding value to the company has begun to mean more than just adding money in recent years. In this way, startup owners may benefit from other assets that certain investors can bring to the table.

Origins of Venture Capital

In one way or another, forms of venture capital have probably financed innovations since people latched onto the idea of bartering. For instance, a plucky inventor may have come up with a better idea for a grindstone but lacked the resources to create it on his own. Another villager may have liked the idea, so he exchanged stone and labor for part ownership in the new and better milled grain producer.

Still, for much of the history of venture capital, investors favored loans over equity. In the past, investors lacked ways to gain good information about all the details of a business. Also, until fairly recently, the concept of limited liability did not exist as it does now. Investors feared that they may offer money to a company in exchange for part ownership. In exchange, they might get unpleasantly surprised by massive debts that the original founders had already piled up. As part owners, they would also face partial responsibility for these loans. The concept of limited liability helped relieve some of these concerns and encourage more equity funding.

It took until after WWII for the United States to develop a true private equity system. An investment of $70,000 in DEC in 1957 gained credit as one of the early success stories after that initial funding grew to $35 million by the IPO in 1968. The Great Recession changed the nature of venture capitalists to some degree. Most lately, venture capital groups have focused more upon offering other value, besides just funding, to the small businesses or startups they want to help fund.

As mentioned above, part of the deal may include business expertise, facilities, and other helpful assets beyond money. Thus, many venture capitalists look for startups or small businesses that they understand how to fix or help, beyond those that just need investments.

Working for a Venture-Backed Company

How is working for a venture-backed company different from working within an established corporation? As we noted in our guide to Startup Culture, working for a startup can offer employees many of the same benefits that investing in one provides venture capital providers. Of course, employees may not initially enjoy the large salaries and perks that a large and established corporation can provide. On the other hand, talented people might choose a rapidly growing small company because they’re excited about the opportunities for economic and career growth they could enjoy in the future.

Because the company is small, employees may need to wear multiple hats, and some employees enjoy the challenge and chance to explore various facets of their company. In lieu of the highest salaries or best retirement plan, some startups also offer flexible schedules and other soft benefits that might also appeal to some very good employees. Working for a venture-backed company offers some challenges over taking a job with an established firm; however, the right startup or small business can also promise great rewards.

 

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