How Venture Capital Funds Work

Posted by in Business & Entrepreneurship

From the inception of having an idea to setting it up and advancing such ideas to the next level, an entrepreneur must think of venture capital funding for such idea or ideas to strive, scale, and move faster. Without the necessary expertise and technical know-how, entrepreneurs and new business owners can take the wrong steps that could backfire in the long run. Even with a great idea or a business strategy that is off its foot, entrepreneurs still need the required skills and expertise needed or the right team to move it to a higher level and all could come to nothing without the right strategy to manage finances.

There are lots of questions to answer: Who to get finance from, when is the best time to raise funds, what are the best terms? In the first place, is the company fundable? However numerous and difficult to answer these questions may pose to be they should be tackled before going on with your idea. Getting answers to these questions will ensure minimal time is being wasted and will increase chances of success. There are a lot of startups and businesses that need venture capital funds but many startups can’t even get a shot at making it to a sought-after investor. As an entrepreneur or business owner, your best chance is that you should be prepared as much as you can.

Who Runs Venture Capital Funds?

Insurance companies, wealthy individuals, and pension funds invest in stocks, real estate, and other assets. They earmark about 10 percent of their wealth into businesses that generate higher yield and have high risks, and they pass those investments through venture capital funds most times. Financial wizards, ex-entrepreneurs, and others like that establish venture capital funds, they agree on how large the fund should be, where the fund should go to, and establish an ‘offering memorandum’. Many investors invest their money into the venture capital fund on this basis and become limited partners in the fund. Once the fund is committed from other investors and pension funds, leaving the fund closed, the general partners find available investment opportunities or ‘source deals’ as they call it. They may look at 50-100 opportunities for each one they pick to fund in exchange for equity.

How do Investors Make Their Money?

A venture capital funds partner gets his or her returns after getting a startup or its initial public offering. A venture capital fund is considered to be doing well when one-third of the portfolio companies provide the partners with such an ‘exit’. The average time-frame to approve an exit is five to seven years, and the lifespan of the fund is 10 years. The general partners take a yearly management fee of two to three percent of the capital injected into the fund, for expenses and salaries. They will also get a 30 percent share of the spoils from exits; usually, after the limited partners have gotten their capital investment back.

What are the Moving Stages of Venture Capital Funding?

Venture capitalists will invest a third of the funds in the 3 years that come first. Depending on the venture capital preference, the fund can be invested anywhere from the early stage to the growing stage. The rest of the fund will go into the follow-up stages for portfolio companies that gain impulse and can be placed up for an acquisition or initial public offering. The rest may be left to their own device. So a basically funded venture capitalist has a three-year life span to get going and move up. The general partners need some early winners, so they can go back to the limited partners to raise another fund midway through the lifecycle of the first one.

The above explanation of how venture capital works should give an idea of how an entrepreneur lands or can land venture capital funding. Taking a look at how to get venture capital funding, what an entrepreneur needs to get funded, and what circumstances may be better in growing his ideas?

Here are the basic questions an entrepreneur needs to ask him/herself before embarking on a quest for venture capital funding.

Do you have a highly-scalable, viable, rapid-growth idea?

Every entrepreneur believes in their startup idea, and that he/she has a brilliant business idea. They should, but that is not enough. Investors and venture capitalists will only back up the idea and invest only if they see the potential and are convinced; especially venture capitalists. Academic credentials, pedigree, and even your idea will only allow you to meet with potential investors but nothing else.

So if, as an entrepreneur or business owner, you are confident of making profits and getting returns, getting venture capital funds may not be your concern. Running it with your own savings, or from your friends and family, will be a better option. On the other hand, if your ambition is to launch a high-flying company and deal with all the stress and problems that come with it, then you will need to go for venture capital funding at some point. The right time is when your idea is poised to start and accelerate along the path of the big leagues.

Does your idea suit venture capital funding?

Venture capitalists lookout for those with big ideas. Having a small, comfortable, and profitable business is not of interest to a venture capitalist. You will need a venture capitalist only if you have the ambition to move your business with big capital. You must also be prepared to move in the fast lane because your investors will want you to reinvest in new startups and sell their stake.

What really is your reason for starting up?

Some people start up just to become their own boss. Others do it for many other reasons. Another set of startup founders is driven by the passion to deviate from the status quo. Possibly in most startup founders, you will find a little of all three, but it’s the third characteristic that appears more appealing to a venture capitalist.

What size of the market are you targeting?

Some ideas or businesses are too small to be funded. A US$20 million may be good to run a business, but remember that investors are looking for quick scaling up and for that, a market in millions of dollars is more like it. If an idea manages to capture a small share of the market, it must be big enough to make the investors get their venture capital fund back.

Are you ready to share control of your idea?

A venture capitalist funded startup will pass through different rounds of funding, and the founders will have to give up a large share of their stock in the process. Venture capital funds always invest large sums of money, in order to get returns on them; they need to have significant percentages of their big ideas. For a founder, all this means getting familiar with the idea that he can’t control the entire quest to make the company grow large. Of course, that does not mean that the founder will not become rich, even a little stake in a high growing idea can be worth millions.

Which venture capital is the right one?

A lot of factors need to be considered here, but what tops the list relates to the value that a venture capital fund can bring to your startup, more than the capital. The advice of an experienced venture capitalist can help cancel mistakes and turn your errors into a valuable experience. They have a connection with potential customers and investors that are invaluable to a startup. Normally, they should be experienced in your field, but at the same time should not have another idea in their portfolio that will be a rival you. And lastly, it’s best to get a fund at the initial stage, so as to get more opportunities for follow-up funding.

Do you have the leadership skills and team to grow your startup into a large scale business?

No matter how good your idea is, or how strong your credentials may be as a founder if you lack a strong team or you are unable to persuade a venture capital fund manager that you have the capability and leadership traits or connections to build a great team, they will be uninterested in what you have to say and will likely walk away from it. Getting from the startup stage to higher levels, investors are looking for needs collaboration and organization. That is why a venture capitalist will try to figure out if an entrepreneur has what it takes to be a good leader.

You should approach a venture capital fund, how?

If you identified a problem in the world and have an idea on how to resolve that problem, and you have worked out a business plan to accomplish it. You know how to build the business to make it grow, how revenues will be obtained, and who the customers will be. You have the markets and their sizes in your plan, as well as obstacles and competitions. Now, do you take all that to a venture capitalist?

The first way is to be selective and studying the past behavior of venture capital funds to see the best one for your startup. The problem is that past behavior is not always reliable guidance on how venture capital funds will invest in going forward because it is in an unmovable state of flux. Another way is to fire off proposals to a lot of venture capital funds in the hope of coming upon one needing a startup like yours.

The third way is to find an accelerator, tech evangelist, or an incubator to back your idea. Screening deals and startups are a hard and time-wasting process. So it will be helpful to have your ideas put together by someone the venture capitalist respects. Pre-screened business opportunities save time for venture capitalists and have a good chance of being funded. The idea is to look for genuine a backer with venture capitalist connections.

With lots of startups looking for venture capital funding, it is the one’s that get venture capitalists to respond emotionally, and not just theoretically, that are most likely to make the cut. The startup journey can be very exciting but it also has a lot of risks. Paying attention to what happens around you can prevent sleepless nights and take you into your dreamland.

Key Takeaways

  • Seeking Venture Capital Funds and investing in it requires a great level of expertise and technical know-how.
  • Investors and venture capitalists will only back up an idea and invest in it only if they see potentials and are convinced.
  • Having the ability to organize a small team and convince investors/venture capitalists that you have the right leadership and managerial traits are very important.