How Does Venture Capital Work: Everything You Need to Know
How does venture capital work is a question that many people starting a new business may find themselves asking.3 min read updated on February 01, 2023
How does venture capital work is a question that many people starting a new business may find themselves asking. When you start a business, you will need money to get your business off the ground. Some of the most common things business owners will need capital for are:
- Rent or purchase of a building
- Money for payroll
Ways to Get Money for Business Capital
There are multiple options for business owners to secure the cash they need to start their business. They can utilize:
- Personal savings - Some owners will fund the startup of their business from money they have saved or through the money they can acquire for personal assets, such as a second mortgage on their home.
- Bootstrapping - There is also the popular bootstrap method. This means that you use a small investment to get the ball rolling on your business and put the profits back into the company to help the business grow. This can be a good option in service industries where the startup is relatively low.
- Bank loans - You can try to acquire a business bank loan to provide the capital that you need.
- Venture capital - There are some investors who are willing to contribute large sums of money to get a new business started. This is ideal for businesses that will need to grow quickly.
Who Are the Venture Capitalists?
There are many people from all walks of life that are venture capitalists. Sometimes insurance companies, pension funds, or wealthy individuals will invest an average of 10 percent of their money in riskier investments such as startups. This portion of their money is invested in what are called venture funds. Unlike other investments, venture capital is unique because the investors often get equity in the company in exchange for the funds.
What Is a Venture Capital Firm?
You may also find a number of financial wizards and ex-entrepreneurs who like to set up and invest in venture capital funds. The general partners of these funds will decide where they want to invest the money and provide an offering memorandum. They then become limited partners of the fund that the general partner will run and manage.
Basically, a venture capital firm will invest in numerous startup companies in return for partial ownership equity in the business. For example, a venture capital firm might invest $200,000 in exchange for having a 15 percent ownership in the business. This can be a win-win for both the investor and the business owner because the owner will get the needed funding and the firm will get to be part of the business's decision-making process.
The general partner will be responsible for investing the money on behalf of the others in the group. They may consider 50 to 100 businesses that might be worth investing in to gain equity. When deals are made, it is the general partner who will sit on the board of the new company to represent them
Initial Public Offering
The venture capitalists will begin to see a return on their investment when the startup has its IPO, or initial public offering. This is the time that the investors will see their returns. A venture capital portfolio is considered to be well performing if at least one-third of the companies it has invested in make it to this stage.
An exit strategy for most startups is around five to seven years, and most funds last around 10 years. The general partner will earn a management fee as well as two to three percent of the fund to pay for salaries and expenses. They also may get 20 to 30 percent of the share of the exit.
To make sure that the fund makes money, they will need to have a few companies that win big in their portfolio. Typically, good portfolios will have about four to five companies that succeed, 10 that fail, and the rest stay moderate.
The venture capital fund will usually invest at least a third of the money in the fund in the first three years it is established. They will invest in either the seed round stage or the early growth round. The last two-thirds will be invested in late-stage rounds of companies to help them gain the last traction they need to make it to an IPO.
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