For many startup companies, receiving investment through a venture capital (VC) firm is the Holy Grail — it's a big validation of your idea and team. It seems like there's always a new story in the news about a startup landing a huge investment, such as the $19M round just closed by Miami-based YellowPepper. While these stories can seem ubiquitous and it's true that last year was the biggest year for VCs since 2000, venture capital is a major catch that requires major preparation to land.
What is a Venture Capital Firm?
A venture capital firm is in the business of raising funds from wealthy individuals and institutional investors then investing that money in new businesses, new products, and new ideas. Such individuals and institutions are attracted to such investments because they offer the potential for making a much higher return than they would find in the stock market or with other more traditional investment products. Plus, these investments can diversity their portfolio.
Unlike traditional banks that fund business loans, venture capital firms tend to fund riskier, less proven projects and companies. Their money is fully at risk, which means if the company fails, their money goes down with it. Businesses don't pay back venture capital money like a bank loan with interest, nor do VC-backed companies have to put up collateral or guarantee the loan.
Since venture capital firms put their money at risk, they like to see a 10X to 30X return to make up for all the companies in their portfolio that fail to return any money at an exit. They also are seeking to generate a return within a relatively short period of time, usually within three to seven years. This generally happens when the company being funded goes public via an initial public stock offering or is sold to another company. This is called a liquidity event, and hopefully the investors receive a multiple of their initial investment.
According to the MoneyTree™ Report, a study prepared by the Venture Capital Association and PricewaterhouseCoopers, venture firms invested more than $33 billion in U.S. startups through the first three quarters of 2014. So contrary to what you might read in some business publications, there is money out there. The secret is making your company attractive to the VC firms that can help your ideas and your dreams become reality.
Tips for Securing Venture Capital:
1. Target VC firms that specialize in your industry. Don't waste your effort and your time approaching VC firms that don't typically fund businesses in your industry. This is where it pays to do your homework. Since these firms specialize, they generally won't be interested in a firm that's outside their comfort zone and realm of knowledge.
2. Make sure your idea is unique. Venture capital firms are looking for new ideas that fill a void in the marketplace. Make sure that your idea isn't something that's already out there.
3. Do a pilot test. If you can demonstrate that your product or service is intriguing to consumers via a small pilot test, a VC firm is more likely to write that check. If you are selling a physical product, such a test can also help you gather vital feedback before your manufacture it in large quantities.
4. Get your team in place. While your product or business may still be on the drawing board, the VC firm can talk with and interact with your management team. Since most VC firms like to get involved in at least the initial phases of the start-up, they'll be looking to invest in people with whom they feel they can work well with.
Not All Venture Capital is Equal!
As tempting as it may be, accepting venture capital from a firm that isn't the right match for you may be worse than not having the capital at all. Because the VC firm that you work with will likely want to participate in management of the new company and help make key decisions, it's vital that you pick a VC firm that's right for you. In a very helpful Entrepreneur article with tips on finding the best VC match for your company, Brady Bohrmann advises to look at past projects the VC firm has funded to get an idea of their strengths. He also suggests that you ask for references from past collaborators to get an idea of their personality and collaborative style.
In addition, make sure that venture capital is the right choice for funding your new company. Venture capital is compelling, but it's not the only funding option available. According to "Inc." magazine, if you only need $150,000 to $200,000 for your project, you're better off with angel funding or soliciting generous friends and family members. Most companies complete a friends and family round first, before seeking angel and venture capital. It's a great way to validate your idea and polish your pitch before you're in the room with the big spenders.
Have a venture capital success story or some tips to share? Join the conversation by tweeting @SparkLabKC!