Venture capital: the full guide

Growing a young business is exciting, but it can also be costly. Venture capital firms could help your business scale by providing finance in exchange for equity.

2 November 2019

Rent, stock, wages, furniture, bills, equipment, supplies. With what feels like an endless list of outgoings, the basics of business sometimes don’t leave much budget for growth. This is why some businesses turn to venture capital as a way to access the funding they need to fulfil the enterprise’s true potential.

But what is venture capital? And how do you get your hands on it?

Despite being a popular method for raising money, venture capital (VC) can seem like a daunting topic. But we’re going to break it down, little by little. Read on to find out how it works, the process for getting it, and whether it could be right for you.

What is venture capital?

At its most basic, venture capital is a business investment made in exchange for equity. By selling equity to investors, the owner gives up part of the ownership of their business, along with some voting rights and a slice of the profits and losses.

Venture capital will typically come from a venture capital firm, who tend to look for emerging businesses that are showing a lot of promise. For them, it’s a game of high risk – but with it brings the chance of higher rewards. VCs invest in new or fast–growing companies in the hope that they can earn a return when the company (which they now own a part of) grows and turns into a success.

This is the ideal scenario, but a happy ending is never guaranteed – and many VC firms will experience high rates of failure, due to the challenges and uncertainties that all new businesses face. But, when it does work, both the VCs and business owners can reap the rewards.

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How does venture capital work?

Venture capital firms gather money from various different sources, such as companies, pension funds and wealthy individuals, and put it all into a fund. With that fund, they can invest in different businesses.

In most cases, the investors will know how their money is being used, as well as all the expected risks and rewards that come with that investment.

Once a VC finds a business they’d like to invest in – and have gone through all the necessary checks and due diligence – they’ll then negotiate how much to invest and for how much equity. The funds will then be released to the business all at once or, more commonly, in rounds. In some cases the VC firm will take an active role in the management and growth of the company.

There are lots of ways VCs can get their money back – whether it's by the shareholders of the company buying them out, another business buying the company they've invested in, or even going public and floating on the stock exchange. No matter what the exit strategy is, VCs usually try to make good on their investment in between 3 and 7 years.

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The difference between private equity and venture capital firms

While both private equity and venture capital firms both raise money in order to invest in companies, there are some differences between the two – how they conduct business is actually very different.

We’ve outlined the key features which will help to clearly set the two apart.

The people

Private equity firms tend to be made up mostly of individuals with backgrounds in investment banking, while those working at venture capital firms tend to have a diverse range of professional backgrounds.

Maturity of business

VC firms tend to gravitate towards exciting and innovative businesses, while private equity firms often choose to invest in businesses that are already established.

Ownership

VCs are likely to ask for a smaller percentage of the company for their investment, while a private equity firm will tend to buy most (if not all) of the company so that they have a majority stake and complete control.

Diversification

Investing is a risky business – but VC firms usually dilute this risk by investing in lots of different companies. This way, if one of them fails, the overall impact isn’t as big. Private equity firms, on the other hand, will look to invest in a smaller number of companies, or even just one at a time – pouring all their effort and energy into it, and minimising the chances of failure.

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How to apply for venture capital funding

For new businesses, it can be hard to convince traditional lenders to part with their cash to fund your venture. Without a proven track record, most young businesses are considered to be too risky. But venture capital funding could be a good alternative if you’re new to the market but have a bullet–proof business plan.

While VC could be perfect for growing your business, it isn’t easy to come by. VCs receive many applications for funding from budding entrepreneur, but by understanding the process a little better, you may be able to stand out in the crowd and capture their attention.

It all starts with a cracking idea. If you’re sat on an idea with the potential to change an industry then you’re already a step closer to piquing the interest of VCs. But an idea isn’t enough. You’ll also need to be able to demonstrate that you have a plan for realistic growth and a strategy for success which will give your investors a great return on their investment. This should all be presented within a business plan and proposal.

This part is just as important as having a good idea. It should be the blueprint to success and contain information such as how much money you need, how long everything will take and your targets – from your audience, to your sales.

If a VC is interested in the proposal, then they’ll spend some time investigating the company – checking background information like how things are run, the business model, etc. If they’re happy, then you can move onto the stage of agreeing the financial arrangement which will be initially documented in what’s called a ‘term sheet’. Whilst a term sheet isn’t a guarantee of the final deal, it does show that a VC is serious about the investment.

How can I find a venture capital investor?

One of the easiest ways to find a VC investor is to start with online databases. That way, you can do some research on who they are, what they’re looking for and whether they’d be a good fit for your business. Industry bodies such as the British Private Equity and Venture Capital Association can be a great place to start.

As well as going it alone, you can also hire a VC consultant who can help you find an investor that matches your business needs. They’ll guide you in your search and support you in assembling and presenting your pitch for investment.

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Advantages of venture capital

Entering an agreement with a venture capitalist should never be taken lightly – so it’s important to know the pros and cons before you do so.

There are a number of benefits that a VC investment could provide for your business:

Knowledge

VCs tend to focus on specific industry sectors and therefore can be a great source of knowledge and expertise in your field. This can be particularly valuable for young start–up businesses who may lack that experience.

Connections

VCs may have a huge number of connections within the business community. Working with a venture capitalist could give you access to this network – helping you to build your own connections that might assist in the growth of your business.

No monthly payments

VC funding may provide your business with a large amount of funding, and unlike a traditional loan there’s usually no commitment to making monthly repayments.

Disadvantages of venture capital

If it’s all starting to sound too good to be true, then it would be worth noting some of the drawbacks of venture capital investment.

Loss of control

Money received from a VC investment may not require monthly repayments, but it does come at a cost. In return for finance, a VC will take an agreed amount of equity from your company. With this they may be able to affect business decisions and shape the future of your business, depending on your agreement with them.

A lengthy process

From developing a pitch, presenting your business plan to receiving an investment – the whole process of applying to a VC firm can take time. VCs are the ones taking the risk and as a result are likely to take their time making decisions.

A 3–7 year plan

Many VCs will be looking for a return on their investment within three to seven years – so this might not be a suitable method of funding for you if your business will need more time to grow and generate a high return on investment.

Non–growth oriented business

Most VCs are looking for large returns on their investment, but many businesses just aren’t designed for fast growth and very large profit margins in just a few short years. How your business makes profit and the speed at which is can do so will likely be key to whether venture funding will work for your business.

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Alternatives to venture capital

Venture capital funding can bring many benefits and has enabled start–up companies to get off the ground. That said, every business is different and VC investment may not be the right solution for every entrepreneur or every business.

Below are some alternative ways to raise the funding you need for your business:

Business loan

If you need quick access to funds to help your business grow, then a business loan could be the right solution. This is when you borrow a fixed amount of money at an agreed interest rate. Businesses without much trading history can struggle to secure such loans.

iwoca offers a Flexi–Loan of between £1,000 and £200,000 to small businesses, which can be paid back over as little as a few days or up to a year. Applying is quick and easy, and can be completed in a matter of minutes. And funds are usually available in 24 hours so you won’t have to wait long to make the most of your funding.

Friends and family

For many businesses, family is the first port of call for business funding. They care about you and your success, so if they have the means they may be open to financially supporting you to grow your business.

Business angels

Business angels are individuals who invest a portion of their own personal wealth into companies, in exchange for equity in the business.

Crowdfunding

Rather than getting your funds from a single source, you can raise they money from a whole ‘crowd’, through business crowdfunding. This could be made up of members of the public or groups of investors.

Grants

The government offers small business grants to small businesses if they meet certain criteria. You could be awarded money that you don’t need to pay back to get your venture started, but given that a grant will cost you nothing it’s likely that this will be smaller than other types of funding.

Martin Brackstone is a senior editor and copywriter who has years of experience writing about a broad range of topics, including business finance, pensions, home and motor insurance, premium bank accounts, reward credit cards and personal loans.

Words by Martin Brackstone

Martin Brackstone is a senior editor and copywriter who has years of experience writing about a broad range of topics, including business finance, pensions, home and motor insurance, premium bank accounts, reward credit cards and personal loans.

Article updated on: 2 November 2019

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