Uber. Snapchat. Instagram. Lyft.
What do all these popular apps have in common (besides being on your home screen)? They were all built and marketed with the help of venture capital.
Venture capital has become a popular way for small or up-and-coming businesses who lack access to bank loans or other forms of financing to raise funds and grow their companies. Although many people are familiar with the term and the funds that come along with it, the ins-and-outs of the venture capital process are often a mystery.
In this article, we’ll explore the definition of venture capital, its various stages, the pros and cons of venture capital, and how your small business can secure funding with a VC firm. We’ll also discuss alternative forms of funding and ways your startup can make the best use of new funds.
What is venture capital?
Venture capital is the funding of startup companies in the early stages with strong growth potential. Generally, these companies aren’t making a profit yet. Venture capital firms tend to invest in companies that need funding, finance, and operational expertise. Many choose to focus on startups in technology-based sectors.
This type of private equity funding means that the investor will get an equity stake in the company in shares. Their investment in a company means that the venture capitalist is free to state opinions about business operations. They can also make changes in the company to help it become profitable and regain its invested capital.
Angel investors vs venture capitalists
Many new companies tend to confuse angel investors with venture capitalists in their search for funding. While both are popular forms of financing for new businesses, there are significant differences between the two.
Angel investors are generally wealthy individuals looking to make investments. They are usually entrepreneurs wanting to invest in early-stage companies in exchange for equity in the company. Although angel investors may offer some advice or expertise to the company, they typically won’t work closely with the management team.
With venture capital funding, high net worth individuals will pool their money together and create a combined fund to invest in new companies. These individuals form a firm with a limited partnership structure. The capital from these limited partners will generally come from pension funds, wealth fund endowments, or foundations.
What do venture capitalists invest in?
Venture capitalists look to invest in companies that show potential for significant growth. Put simply, they’re looking for companies with:
Airtight management: VC's don’t want companies with messy, inexperienced employees. Companies with confident and knowledgeable executives and managers are more likely to attract venture capital firms.
Exclusive products: While some VC firms invest in service-based companies, most look for startups with exclusive products. Products with patents or copyrights are viewed as favorable investments.
Growing markets: Remember that VC's want to invest in high-growth companies. This means that the market must also be growing. Your business needs to demonstrate both business and market growth to secure funding.
Detailed operating plans: As a startup, your business plan can double as your operating plan. If you’re an existing company, you’ll need to show an investment plan that details how you plan to use the venture capital investment.
High chance of initial public offering (IPO): Although most venture capitalists are interested in long-term investments, firms still want to see high returns. Your company should have the possibility of an IPO. There must be a clear exit strategy should another company acquire your business in the future.
Stages of venture capital
You can break down the venture capital process into five different stages. While there’s no universal model, most VC firms will follow similar steps. Let’s unpack what startups typically go through when looking to secure funding.
All venture capital financing begins with the seed stage. The company isn’t more than an idea or service at this stage. While it may have the potential to develop into a viable product later down the line, startups in this stage are trying to convince VC's that their idea deserves support.
Funding amounts in the seed stage are typically small. Any funding given to startups is used for research or product development. The goal is to create a product that will attract investors in future funding rounds.
In the seed stage, companies have already completed market research and created their business plans. Now, they will start advertising and marketing their product to potential customers.
Companies will have a prototype to show customers and potential investors, but they haven’t sold any products yet. They’re trying to work out the kinks from their product or service and fine-tune it for a future launch. To do this, they’ll need a larger amount of funding than the one they received in the initial seed stage. This funding may also go towards personal expansion or additional research to launch their business.
Early stage/first stage/Series A
The early stage, also known as the “emerging stage,” begins when the company is ready to launch its product in the market. This stage reveals the product's potential in the market and how it stacks up against the competition.
Funding received in the first stage is used for manufacturing, sales, and increased product marketing. Businesses will often require more funding to have a successful and official launch. You can expect to see larger funding amounts in this stage compared to previous ones.
Companies in this stage are often moving towards profitability. If the startup and its product demonstrate a solid place in the market, the venture capital firm will allow them to proceed to the next stage.
Expansion stage/Series B
At this stage, growth should be exponential. To keep up with consumer demands, companies will require more funding. Their product should be thriving in the market and the company should be bringing in revenue.
Companies will use the funding received in the expansion stage to scale their business and widen their market share. They might choose to expand to additional markets in other cities or countries or look to diversify their products. Some companies use this time to reduce production costs and start new marketing campaigns. Once this is done, the venture capital firm examines the actions of the management team and how the startup fairs with its competition.
In the final stage of the venture capital financing process, companies should be ready to go public. Funding secured in this stage goes towards mergers, acquisitions, or IPOs. Businesses may also perform price reductions or take measures to eliminate competition in the market.
Once this stage is reached, investors choose to sell their shares, exit the venture, and receive a return on investment.
5 notable venture capital firms
As of 2022, these are the top five VC firms in the world. They are ranked based on their investment to exit ratio:
1. GV Ventures - 23.86%
Originally founded in 2009 as Google Ventures by Bill Marris, GV Ventures is a venture capital firm partnered with Alphabet, Google’s parent company.
GV Ventures tends to focus on early-stage, late-stage, and seed funding, but have recently adjusted their focus to include mature companies. Currently, GV Ventures has 8 billion dollars worth of assets under management.
Their website reveals that GV ventures invested in companies like Uber, Slack, RetailmeNot, HomeAway, Nest, HubSpot, Cloudera, and more.
- Healthcare startups
- AI/Robotics startups
- Consumer products
2. Bessemer Venture Partners -22.92%
Bessemer Venture Partners has invested in popular names like Pinterest, Shopify, and LinkedIn. Founded in the US, this Silicon Valley-based VC firm currently has close to $19 billion in assets under management.
BVP is mostly interested in startup entrepreneurs looking to make a change in the consumer or enterprise industries.
- Healthcare startups
- Consumer startups
- Enterprise startups
3. Insight Partners - 22.68%
Founded in 1995 by Jeff Horing and Jerry Murdock, this New York based private equity firm is known for its love of software. Their portfolio consists of scalable software and internet businesses, and they invest in both early and late-stage companies.
With over 600 investments and 25 years of experience under its belt, Insight Partners specializes in accelerating revenue and profit in software companies. They’ve helped over 55 companies achieve an IPO worldwide.
- Software startups
- Internet startups
4. Index Ventures - 21.91%
Index Ventures was created in 1996 and currently runs out of San Francisco, London, and New York. Backing companies from the seed stage to IPO, Index Ventures has companies like Notion, Glossier, Etsy, Slack, and Roblox in their portfolio.
They’ve helped startups from various industries grow to independence, but they especially focus on gaming, security, e-commerce and fintech niches.
- Fintech startups
- Ecommerce startups
- Gaming startups
5. Sequoia Capital - 21.28%
Sequoia Capital is one of the most well-known VC firms for tech startups. Known for investing in tech giants like Facebook, Whatsapp, Google, and Apple, this Menlo Park-based firm has spread its influence worldwide. With offices based in Southeast Asia, Europe, and America, they are constantly looking for the newest high-growth startup.
- Tech startups
- Fintech startups
- SaaS startups
Pros and cons of venture capital funding
With all forms of funding, it’s crucial to consider the pros and cons. Weighing these out can help you decide if venture capital funding is the best choice for your business. These are 5 advantages and disadvantages of venture capital:
Access to expertise: In the early stages of your business, expertise is invaluable. Many startup owners go on to form their own venture capital firms after exiting their businesses. As a result, they have plenty of advice, guidance, and experience to offer young businesses.
No obligation to repay funds: Venture capital firms invest in new businesses and receive equity in return. Unlike traditional bank loans or small business loans, you won’t need to make payments on the funds you receive. You can use this money to improve products, perform market research, or streamline operations.
Helps businesses grow quickly: New businesses tend to grow slowly due to a lack of resources. Your small business may struggle when dealing with legal and tax matters. A VC investment comes with support in these areas, helping you navigate unfamiliar business situations.
Build networks and connections in the business world: Startups may struggle to build connections and network with influential people who can help the business grow. VC firms are well connected, with members dedicating hours of time to networking. Gaining access to these networks can help you hire top-tier talent, raise future rounds of funding, or even build out your clientele.
Increased exposure and credibility: New founders don’t have much, if any, credibility to their name. Venture capital firms come with public relations teams to help your startup get exposure and increase publicity. You’ll get the right eyes on your company, which can contribute to partnerships or future funding from other firms.
Potential loss of influence in the company: Although you escape the need to repay funds with a VC firm, you give up your company's equity shares. This lessens the number of shares you have. Over time, the loss of shares could result in reduced influence and decision-making power.
Potential undervaluation: Some VC firms may pressure the company to go public, so they can exit the venture. This could lead to listing the company too early and undervaluing the shares of the company. While the VC firm may benefit, the company owner could experience loss.
Raising funds can be difficult: In 2020, the National Venture Capital Association reported that only about 5,000 venture capital deals were made in the US. Of those 5,000, 60% of them had already received funding in the past. Companies will likely struggle before finding a venture capital firm that invests in their business.
Need to reach milestones to gain access to funding: Funds secured from venture capital are only released once the startup meets certain performance goals. These goals vary between businesses but often include milestones related to revenue or other metrics decided by the VC firm. If you underperform, you could be let go from the firm.
Extensive due diligence process: Venture capital funding requires a detailed due diligence process. Since the firm is investing money that belongs to external contributors, they need to do their part in choosing investments with a lot of potential. They’ll first examine your business to see if there is a current market need for your product and the scalability of your business. Then, they’ll perform background checks on your team and look into your financial and legal position.
Recent trends in venture capital funding
The recent economic downturn changed the venture capital world as we knew it. Rising inflation and the pandemic strongly impacted the VC industry. Let’s take a look at some recent trends in VC funding and what this means for up-and-coming startups and aspiring entrepreneurs.
1. Venture capital departs Silicon Valley
Silicon Valley has always been a hot spot for tech companies that secure VC investments. Before 2020, most founders chose the Bay Area, specifically San Francisco, as the best place to house their startup for long-term success. In 2021, this same survey revealed that many founders now choose to be remote or distributed throughout the US.
With this in mind, young startups with remote workers shouldn’t feel limited to any one location. VC's will likely expand their scope of potential startups outside of Silicon Valley, perhaps looking to other overseas markets to award VC investments.
2. Sustainable investing
The venture capital industry has recently turned its attention to sustainable investing. Global trends and an increased focus on environmental concerns have moved many VC firms to invest in companies involved in public health and climate change.
This trend has become apparent with the emergence of several unicorns—privately held startups worth over $1 billion—in the field of sustainability. Companies such as Octopus Energy, Babylon Health, and British Volt are just a few startups pioneering ideas such as green tech and accessible healthcare.
With the size of the global blockchain market expected to reach $39.7 billion by 2025, it’s safe to say cryptocurrency is here to stay. While cryptocurrency is related to fintech, you can expect this trend to begin to stand on its own two feet.
Cryptocurrency isn’t as regulated as traditional investing, and its alternative trading approach makes it an interesting market to get involved in. Instead of an initial public offering, crypto companies use an initial coin offering. With this, companies can raise funds through their digital coin. VC's looking for alternative ways of funding may find this method worthwhile.
4. Lower funding rounds for new companies
Although VC firms continue looking for new startups to invest in, they are hitting the breaks after a record year of funding in 2021. Startups can expect to see lower initial valuations and even “down rounds,” where the company’s valuation at a funding round is less than in previous rounds.
However, not everything is doom and gloom. New startups can turn to alternative forms of funding to ride out the wave of lower valuation. Others choose to use equity crowdfunding or work with angel investors to get the finances they need for their companies.
How to get venture capital funding as a startup
Earlier, we discussed the various stages of VC funding. However, what exactly do startups need to do to acquire venture funds for their business? What will help you appeal to VC firms and angel investors? Here is some step-by-step guidance to help you secure funding for your small business:
1. Define business valuation
Before beginning your venture capital application, establish the value of your business. Trading equity for funding means that the more your business is worth, the more funding you stand to get. You might choose to use a business appraiser or statistical models to value your business.
Remember that venture capitalists may lower your business value once negotiations start based on other factors. They’ll look into your company's age, growth speed, revenue and cash flow, and your potential user or customer base.
2. Determine the amount of money you need
When determining the amount of money you’ll try to raise, think about these factors:
- The capital needed to grow your business: How much money will you need for product development, hiring personnel, market research, etc?
- The current stage of your company: Have you already raised funding before? What are the current needs of your business?
- Valuation vs. dilution: Dilution is how much ownership in your business you’re willing to give up. The less money you raise, the less ownership you’ll need to part with. Let’s say you need to raise $3 million but only want to give up 25% of your ownership. To achieve this, your company will need to be valued at $12 million.
3. Create your pitch
Every business will need to create a slightly different pitch. However, most pitches should include:
- Business plan/business model: Business plan outlining information about your company
- Pitch deck: Business plan spread across several detailed pages or slides. Discusses your product, what it solves, the current market, financials, and the amount of funds needed
- Product demonstration: Demonstrate your product and explain how it solves problems for your customers
- Product documentation: Includes product support processes, distributions, manufacturing, and customer service
- References: Personal, customer, and prospect references for the VC firm to consult
4. Search out potential investors
Start by making a list of potential venture capitalists. Most firms will characterize themselves by the round of funding they choose to participate in. Some firms only partake in Series A funding, while others prefer to get involved during Series B. See if your chosen firms are interested in your startup industry. If so, you have a higher chance of getting your foot in the door.
Once you have your list, use your network to get a warm introduction. Cold calling isn’t very popular in the venture capital world. Instead, try to meet naturally or use public relations to get your business and product in front of the right people.
5. Engage in negotiations
Once you’ve found your VC partner, negotiations begin. These typically take place via a term sheet that outlines the investment details. You’ll discuss business valuation, the type of VC investment, and stock option pools. You’ll also discuss liquidation preferences, the number of board seat venture investors receive, control of business activities, and how your business will pay back expenses incurred by the VC firm.
6. Perform your due diligence
Once both sides agree to the term sheet, the firm will start the due diligence process. They’ll explore all the details of your business, such as:
- Business model
- Sales and marketing plans
- Company culture
- Market and competitors
- Current and potential customer base
7. Close the funding deal
When you’ve negotiated all terms and passed the due diligence process, it’s time to close the deal. Both parties will get copies of all your agreements and closing documents for attorneys to review. If everything checks out, you’ll have secured your funding from your venture capital investors.
Alternative forms of funding
Venture capital makes it possible to raise large amounts of funding at once, but it’s not for everyone. All businesses need working capital to grow and thrive. However, you might feel that other alternative funding options are a better fit for your business.
Let’s dive into four alternative forms of funding to help you extend the working capital of your business.
This is a flexible type of funding for companies with recurring revenue. With programmatic funding, companies gain access to a hybrid revolving line of credit where they draw against their annual recurring revenue. As your revenue grows, so does your line of credit.
This form of funding only requires you to pay for the capital that you use. You avoid taking out capital you don’t need or paying for money to sit unused in your bank account. While traditional loan agreements often come with hidden costs and fees, programmatic funding does not.
Businesses get a fixed annualized discount rate that is paid off over the course of the term in smaller, fixed monthly installments. You’ll know exactly how much you’ll need to pay each time you draw against your revenue.
This funding is a great fit for new businesses pressed for time. Unlike venture capital or bank loans, your business can secure programmatic funding in under a week. This means you can secure the funding you need quickly and get back to what matters the most—growing your business.
Commerce-based sales underwriting is a quick way for businesses to secure a credit limit.
This form of funding uses commerce platforms, web stores, and marketplaces to underwrite business credit limits using commerce sales data.
This is very different from traditional underwriting. Instead of needing several years of finances to secure credit, companies only need to have a year of sales history of e-commerce platforms to qualify for evaluation.
Once approved, businesses can enjoy higher credit limits and access to finance automation platforms to manage their new capital.
If your business is a retailer, wholesaler, dealership, or seasonal company, inventory financing could benefit you. Inventory financing is when your company borrows money from a bank and uses your existing or future inventory as collateral.
Although inventory financing is pretty straightforward, there are some drawbacks. Should your business default on your loan, the bank can seize and sell your inventory to make up the remaining loan amount. Businesses will also need to pay loan applications, appraisal, repayment, and late fees for untimely payments.
If you choose inventory financing as your preferred method of funding, you’ll need to have a solid track record in your industry. Otherwise, lenders may choose to give loans to more established businesses instead.
The term e-commerce financing applies to, you guessed it, e-commerce companies. Upon inception, smaller e-commerce businesses struggle to get the financing they need due to a lack of revenue. To stay afloat, many turn to business credit cards.
They use their business credit card to purchase merchandise to sell on their website. This gives the company thirty days to market and sell its inventory. While this may work for a while, the business growth is hampered by the card limit.
Now that you have funding secured….
Securing funding is only half of the battle. Once you’ve got the finances you need to help your business grow, set limits in place to use it to the fullest.
Ramp offers spend controls that allow you to control spending before it happens. Create cards that set limits on vendors and daily spending. Control large expenses with transaction limits while giving employees the flexibility to request exceptions.
Create flexible expense policies and set guardrails to control employee spending. These options let you stay in the know and take action immediately when out-of-policy spending happens.
Let Ramp help you take control of your funding
Many businesses work hard to secure funding for their company. Once they have it, they struggle to streamline the business's day-to-day operations to get the most out of their money.
Ramp helps businesses strengthen their finances by providing them with real-time insights into how they spend their money.
Find out how Ramp can help you take control of your funding now.