Venture capital provides financing to startups with growth potential. To access it, know how it works, make key company decisions, negotiate with firms, understand constraints, and have a returns plan. Timing is crucial - align with the VC lifecycle. VCs and entrepreneurs should see each other as partners in creating companies, not opponents. VCs need ideas, commitment, and growth from entrepreneurs. In turn, VCs provide capital, expertise, and mentoring to young companies. By understanding how VC works, more beneficial partnerships can form between VCs and entrepreneurs to build successful companies.
Venture capital has become an essential source of financing for innovative startups over the past 30 years. Major tech companies like Amazon, Apple, Facebook, and Google were backed early on by venture capital, as were many other successful enterprises. A 2015 study found that VC-backed public companies accounted for a sizable portion of total market capitalization and R&D spending in the US economy. Yet the VC industry represents only a tiny fraction of overall capital invested in the economy. So why do entrepreneurs seek venture capital, given the small size of the industry? Many startups simply won't generate enough near-term cash flow to qualify for traditional bank loans. Instead, founders offer equity to VCs in exchange for the capital needed to start and grow their companies. VCs invest in early-stage firms with the goal of selling their equity stake later at a significant profit. Since not every investment succeeds, VC firms typically have a portfolio of investments. Historical data shows that around 50% of VC investments end up impaired and return little or nothing. Another 20-30% are moderate successes that return 2x the investment. The remaining 10-20% are major hits that return 10x to 100x the capital invested. When evaluating potential investments, VCs generally look at three key criteria: The team - their background, experiences, and likelihood of executing successfully. This qualitative assessment of the founders is usually the most important factor. The product - does it solve a real market need that customers will pay for? VCs look for 10x improvements over existing solutions. The market size - does the product have the potential to reach a large addressable market? VCs only invest in big opportunities. Most VC firms are structured as partnerships with outside investors providing the capital and general partners making the investments. Typical outside investors include university endowments, philanthropic foundations, pension funds, family investment offices, sovereign wealth funds, and insurance firms. These limited partners aim to diversify their portfolios and generate above-market returns through VC. Incoming capital is pooled into sequential numbered funds, usually lasting 10 years. Older funds face greater pressure to produce returns and successful exits. Entrepreneurs should understand the timing constraints of any VC offer to invest. The motivations of their backers heavily influence how VCs operate. Limited partners expect significantly higher returns than public market benchmarks over the lifespan of a fund. This expectation shapes the high-risk investing strategy employed by VC firms. Knowing the incentives and pressures faced by a VC before seeking funding is advisable for entrepreneurs.
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