What is Venture Capital?

Securing venture capital funding can prove to be a fortune for a new, inexperienced business. But venture capitalists (or VCs) are not buying into the risk and uncertainty for nothing...

In exchange for funding, VCs are likely to ask for equity in the company they’re investing in. That gives them part-ownership and a say in decision-making. A VC may also ask to sit on the board of directors of the company it backs. When selecting an investor, founders too are entering a gamble, too, because they typically give up some ownership stake in their company in exchange for funding, as well as reduced control, in many cases. Plus, the process to secure funding isn’t always straightforward. VCs are often professional investors with a ton of industry and investment experience. To select investors who are at the top of their game, entrepreneurs need to be on top of theirs, too.

Private equity and venture capital firms perform similar tasks— Both make calculated investments in private companies to increase their value and profitability, with the hope of garnering substantial returns down the line. Both do so by raising funds from financially-qualifying individuals and institutions. They’re related, but they are not the same. Below are three key differences in business operations and overall motivations that can set them apart from each other:

• Age and size of the investee: Private equity firms tend to invest in older, more established companies that have been in operation for a while. For example, in 2014, a leading private equity firm called Bain Capital invested in the popular American shoemaker TOMS Shoes Inc. after it had been in business for about 8 years. On the other hand, venture capital firms focus on giving fresh, emerging businesses and startup ideas the financial resources they need to set the ball rolling.
• Size of the investment: Private equity firms spend hundreds of millions, even billions, of dollars while investing in companies. Investments made by venture capital firms are relatively smaller and more incremental. A venture capital investment in a startup in its early stages, for instance, may not exceed $10M. As the company grows and its business expands, venture capitalists may invest more and more.
• Risk and uncertainty: Between the two, private equity firms are the ones playing it relatively safe. This is because the companies they are investing in are older, have a track record to assess and enough performance data to analyze. Venture capitalist firms, on the other hand, may find risk charming. It’s part of their job to sniff the long-term potential of an idea when it is only a business plan, not an actual business in operation.

If private equity is for teenage and adult companies, and venture capital is for toddlers, angel investing is for newborns. An angel investor is a wealthy individual with deep pockets who jumps in at the very beginning of a business idea’s life cycle to support its transition into a real business. In other words, an angel investor is committed to the long idea of an embryonic company that has little or no capital.

Angel investing is a subset of venture capital and usually involves an investment lower than venture capital. Angel investors are literally helping to plant the seeds for a business they hope will bloom. That’s where the kind of funding they provide, seed funding, gets its name.

However, angel investing involves a single individual shelling out dollars. That makes it all the more crucial for an entrepreneur raising funding through an angel investor to differentiate between a professional and proficient investor who is adept with processes of due diligence and product analysis, which can help guide the fledgling company, versus someone who is investing with less expertise or experience.

Angel investors and venture capitalists may also differ in their expectations from the business they invest in. As mentioned above, venture capitalists seek equity in the company and thus, a say in the company’s decisions. They may or may not take on mentorship. Angel investors, however, are likely to mentor and advise the company they’ve invested in and ensure they sustain on a path to success.

1. Startup stage: At this stage, the investment is focused on a newly-minted company, or a startup, that has just about begun revving its engines. The startup’s founder may have made a personal investment to develop the idea or venture. There is still plenty of room to build experience with customers and revenue. So the startup is seeking both funding, as well as advice and guidance on navigating the industry and market. This is when an angel investor is likely to step in.

An angel investor can make a necessary investment (typically <$1M) to back the company’s concept. Bear in mind that an angel investor is making more of a personal investment and may be more comfortable funding local companies and those with personal connections.

1. Seed or early stage: A startup is at the seed or early-stage of funding after some sense of its potential for success has emerged. Experience with cash flow and revenue may still be limited. But, by and large, the venture is ready to hit the ground running. This is when a venture capital (or VC) fund can play a significant role.

At this stage, organized groups of angel investors and VC funds dedicated to early-stage ventures may make an investment (typically $5M - 20M) and guide the startup through challenges ranging from those that are industry- and management-specific, to others that may be more specific to an individual business. Like, building back-end systems, or closing sales. Mentorship on transforming mindset to experience more success in the business may also be available when it is actively sought out. It is worth noting that early-stage VC funds may consider geographic proximity of the startup while making a decision to invest.

1. Growth stage: A company is already on the highway when it is ready for a growth-stage investment. In other words, a lot has been established— a business model, profitability, and a clear path to growth. A growth-stage investment can help a company travel deeper into newer, less-traveled markets.

At this stage, a potential investee is able to attract robust investments from venture capitalists across the country.

1. Late stage: A late-stage investment takes place when the business has accumulated enough miles. A profitable company seeking to raise funding for goals that are more strategic, such as expanding overseas or investing in sales and marketing, are eligible for late stage funding. The motivation is to crush the competition and gain a significant advantage in the market.

At this stage, a group of venture capital firms with large pools of funds may come together to make the investment.

Just like the ventures they invest in, venture capital (or VC) firms also raise the funding they can make available for investments. Partners of a VC firm pull together funds from institutional investors like hedge funds, endowments, insurance companies, and foundations. In exchange for the funds, they owe returns to their investors. In other words, a VC firm sits at a powerful spot between those who need the money and those who can provide it. With great power, however, comes great responsibility. So, it is crucial for VC firms to earn a profit on their investments so that their investees succeed and in turn, they can give their limited partners their money back.

It is important to understand how venture capital (or VC) firms are structured to gain clarity on who to approach for funding. Below is how a VC firm is typically structured. Job titles are listed in order of hierarchy.

• Analyst: They are typically the most junior members of the investment team. Analysts tend to have at least 2 to 3 years of experience in banking, consulting, or in a startup. They’re not out on the field and are not the ones making final decisions. What they are doing is due diligence and analysis of potential investments.
• Associate: Associates have a more people-facing job. They’re out in the field hearing out ideas and evaluating them. Their reconnaissance can help narrow down potential investments for a firm. Associates have the ability to help open the flood gates of funding by giving the green signal for a potential investment to be brought to the attention of higher-ups in the firm.
• Principal: A Principal is usually a senior, well-networked member of the investment team whose job is to discover promising entrepreneurs and bring them to meet the firm’s senior leadership. They’re not the ones leading deals, but are the ones bringing in the deals with the ability to set up the right meetings with the right people.
• General Partner: These are the members of the team wearing the big decision-making boots. A General Partner’s (or GP’s) word will carry a large amount of weight as the firm decides what deals to close and which ones to pass. A GP can suggest a potential investment and have their team take a vote on it.
• Limited Partner: VC firms are typically set up as limited partnerships. The limited partners are in fact the owners and the source of capital for the firm.

If you have an impressive CV complete with an MBA degree and a few years of experience in consulting, investment banking, or a startup, you may fill some of the common requisite criteria to become a venture capitalist (or VC) and enter the investing arena. Since venture capital firms are often focused on funding innovation in technology, specialization and expertise in a technical field can help give you an edge. Some of the skills that are indispensable to a VC’s job include sourcing deals, doing due diligence, negotiating, and financing. Besides strengthening the hard, technical skills, focusing on fortifying softer skills like building a strong social media presence on sites like LinkedIn or Twitter, and actively taking on the enterprise to network within the entrepreneurial community can go a long way.