In the mid-1900s, George Doriot started the first publicly traded venture capital firm, and forever changed the way new companies are founded. Up to this point, most new companies relied on wealthy families as a source of capital. Doriot’s firm, however, changed the narrative when it became the first startup to raise money from other private sources.
This firm, the American Research and Development Corporation (ARDC), managed to accumulate millions of cash from educational institutions and insurers. Soon, ARDC alums branched off to form their own firms, founding Greylock Partners and Morgan Holland Ventures.
Shortly after, Congress passed the Investment Act of 1958. This act allowed the Small Business Association (SBA), still in its infancy, to license small business investment companies, changing startup financing to resemble modern-day venture capitalism. Venture capitalists could now invest in new high-growth potential businesses that traditional banks deemed too risky for investment.
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What is Venture Capital?
Venture capital (VC) is a type of private equity that allows investors to support startups and businesses with high growth potential. In return, the startup provides the investor with equity in the company. Instead of expecting scheduled paybacks, like they would with a bank loan, VCs look at long-term benefits like going public, to give them outsized returns.
Venture capitalists fill the funding void between the government, large corporations, and traditional lower sources of capital. The venture capital industry provides a sufficient return on capital that attracts a myriad of participants, private equity funds, and potential employers. As a result, venture capital is now commonplace among new and upcoming businesses.
Venture capitalism still carries a fair amount of risk for investors. Without an obligation to pay investors, VCs have no choice but to eat their losses if a business goes under. The payoff, however, is an attractive counterpoint, as it promises above-average returns if the business is successful.
Investing in startups is an especially risky practice for VCs as such businesses have little-to-no sales momentum save for a conceptual business plan. Therefore, VCs are very selective about providing business funding to startups. Despite these challenges, venture capitalists still invest millions of dollars in these tiny and untested ventures with the hope that they’ve tapped into the next big “unicorn”.
When considering investing in a startup, VC investors tend to evaluate the following benchmarks for signs of potential:
- Solid Management – When evaluating a startup, venture capitalists want to see a team of executives who have successfully built businesses that generated high returns. VCs typically only want to invest their time and sign their checkbooks for management teams with a proven ability to execute the business plan.
- Market Size – Any good business plan should contain a thorough market size analysis presented from top-down and bottom-up. The report should include feedback from potential customers and their willingness to buy the product(s) in question. The report analysis helps demonstrate that the startup targets a large and addressable market opportunity, prompting VCs to invest.
- Competitive Edge – Before contributing funds, investors will first confirm that a business provides great products and services with a long-lasting competitive advantage. They will only invest in a new business if it solves relevant problems that other companies haven’t solved. In addition, they are looking for businesses dealing with products and services that customers cannot do without, either because they are of the highest quality or are very affordable.
- Minimal Risks – Before taking a stake in a seed-stage company, investors want to know what they are getting themselves into. When approached with a business plan, they will want to see what the business has accomplished and what they expect to accomplish in the near future.
How venture capitalists evaluate and minimize their risks depends on the type of fund and individuals making investment decisions.
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What is a Venture Capital Firm?
In most cases, business startups have lower chances of getting funding from banks or other money lending institutions since their business is a riskier investment.
A venture capital firm consists of wealthy investors willing to grow their wealth by investing in high-risk startups that traditional banks are unwilling to take on. Due to the elevated risk of these investments, venture capital firms charge higher interest rates than other lenders.
How a Venture Capital Firm Works
Venture capital firms operate under an investment profile that dictates the type of businesses the firms can invest in. Choosing a target market helps these firms narrow their industry scope, and ultimately guides them in their decision-making.
There are two major players to consider in a venture capital firm:
- General partners are those involved in making investment decisions, such as finding startups and agreeing to the terms of the agreement.
- Limited partners are people and organizations in charge of availing the capital necessary to complete investments.
Limited partners entrust their money to the general partners, who invest in qualifying startups and companies. Unlike other business funding options, VC funds invest that of their limited partners, not their own money. General partners may invest their money in certain circumstances, but it usually only accounts for about 1% of the fund.
As mentioned, venture capital is a risky investment. As a result, startups need to fundraise to convince venture capital firms to provide the business funding in exchange for equity. On the other hand, general partners need to convince the limited partners to invest their funds in a startup with the promise of huge returns, about 5-10x their investment, in a given period.
Once funded, general partners need to make smart investments to pay back the limited partners their investment plus profit.
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What is a Venture Capital Fund?
Venture capital funds are pooled investment funds that provide business funding to startups in exchange for equity. As we’ve established, these investments have a high degree of risk but typically promise high return opportunities. Therefore, venture capital funds must ensure that these enterprises have a strong potential for growth before placing their stake.
Unlike hedge and mutual funds, venture capital funds focus on business startups with high-growth potential. Venture capital funds play an active role in the investments by providing guidance and holding a seat on the board. When a venture capital fund invests in your startup, you should expect venture capitalists to have a hands-on role in your company’s management and operations.
Differentiating Between VCs and Angel Investors
Venture capitalists and angel investors are people who take calculated risks before investing in businesses. They do this with the hope of getting a high return on investment. However, the two have various significant differences:
- Venture capitalists invest in small startups with money pooled from limited partners such as large corporations, pension funds, and investment companies. Angel investors use their own money to invest in small businesses.
- Venture capitalists tend to invest in already established businesses, while angel investors typically invest in companies that are just starting.
- Venture capitalists usually have access to more funds and may invest more money in a business than individual angel investors. As a result, the VCs expect higher returns of around 25%-35%, versus angel investors, who expect 20%-25%.
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How to Secure Venture Capital
Although there’s no universal model to follow when securing venture capital funds, most firms follow these funding benchmarks:
The funding you get at this stage helps fuel your startup’s growth down the road. You may not have a commercially available product at this stage, but a well-documented business plan that convinces investors that your business idea is worth supporting.
You get into the series A stage after completing your business plan. At this point, you are honing the product and establishing your client base. This stage is characterized by a lot of marketing, advertising, and strategizing.
Later Stages (Series B, C, D, etc.)
The late stage is for mature companies that have proven growth and are generating steady revenue, whether they are making profits or not.
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Navigating Taxes and VC Funding
If you get a venture capital fund that’s less than $150 million in assets under management, Congress allows you to register as exempt reporting advisers (ERA). However, you have to meet certain conditions. For instance, you need to register with the SEC under limited compliance and reporting regime, which simplifies and reduces the cost of running the venture capital fund.
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