1. How Do VC Funds Work?
2. Stages of VC Funding

Entrepreneurs commonly ask, “What is VC funding?” The short answer is venture capital funding, or VC funding, is capital that you get from investment groups that work with startups and small businesses. These groups oversee the money of investors who want to invest in companies with strong growth potential in exchange for an equity share in the business. VC funding is one way for small businesses to get money to start or grow their business.

Most venture capital investments are considered to be high risk / high reward opportunities. Investors look at a company's size, assets, and product development pipeline when choosing their VC investment. Compared to other types of investments like hedge funds or mutual funds, venture capital funds focus only on early-stage investments. Changes in the investing world have made venture capital investments more accessible to a wider variety of legitimate investors.

Venture capital firms typically take an active role with their investments and often request a seat on the board, so they can provide more guidance. It is common for a VC fund to invest smaller amounts of money in a larger number of startups in hopes that at least a few of the companies will grow into larger, profitable companies. Spreading out the capital helps the funds lessen some of the risk that comes with investing in new companies.

How Do VC Funds Work?

Depending on how mature the business is when the investment occurs, VC investments are classified as either seed capital, early-stage capital, or expansion-stage capital. No matter what stage the investment is in, they all follow the same basic process:

  • VC funds raise money before they can make any investments. The fund sends a prospectus to potential investors who then decide if they want to add money to the fund or not. The fund's operators secure each investment.
  • The VC fund looks for private equity investments that can bring in positive returns. This process can take a long time and often requires sorting through hundreds of business plans to find the companies with the highest growth potential. Fund managers make the final decisions based on what the investors expect.
  • Once an investment is finalized, most funds charge an annual fee of around 2 percent, which helps pay the salaries of firm directors and other operating costs. Some large funds only charge for invested capital or lower their fees once investments have lasted more than a few years.
  • Returns are given to investors of the VC fund when the company leaves the fund. This either happens through an IPO or if the company merges or is acquired by a larger company.
  • The fund maintains a portion of the profits when a company exits, which usually equals around 20 percent. Expected return varies based on the economic state and the type of portfolio companies, but most VC funds aim for a gross return of around 30 percent.

Stages of VC Funding

Many devices, apps, and services that people use daily began with VC funding. This includes popular apps and services like Uber and Lyft. Startups have been raising more money lately. In 2013, VC funding totaled almost $11 billion, which was a 17 percent increase from the year before.

Not every startup uses VC funding, however. Less than 1 percent of all startups land a deal with a VC fund. Getting the right VC investors can start the company on the right foot and help it gain powerful partners and funding. Paying attention to technology VCs are funding can also help entrepreneurs and investors know new trends in technology. Before bitcoin was a household term, it landed deal with VC funds in 2014 that started its growth trajectory.

The first stage of VC funding is for seed capital. This round is called the seed round because it is the earliest stage possible. Seed capital is typically small and given to companies that don't have a product that is ready for commercial distribution. Money gained in a seed round is usually used for research and development, which means startup leaders are pitching an idea, not a tangible product. Seed capital is also often used to hire more team members and do research into the marketability of a product.

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