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How Does Venture Capital Work?

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Last editedJune 20213 min read

You need funding to fuel growth, so what are your options as a small business? Venture capital financing is one option, providing the boost in cash flow needed to fuel innovation and nurture talent. Find out more about how venture capital firms operate, and whether this funding option is right for you.

What is venture capital?

Venture capital is a type of financing provided by investors to small businesses deemed to have long-term growth potential. This transaction also serves as a type of private equity. When investors offer funding through venture capital firms, they receive equity in the company in return.

Venture capital can be a lifesaver for brand new businesses who don’t yet have a lengthy operating history to show banks. Investors understand that there’s a high level of risk involved with a venture capital investment, but the payoff can involve above-average returns.

How does venture capital work?

Companies, investment banks, and well-off individuals put their money into investment funds managed by venture capital firms. As with other types of financial management, the firm takes care of the portfolio, looking for suitable start-ups to provide working capital in exchange for partial ownership. There are a few differences between venture capital and private equity, however, including the fact that venture capitalists tend to focus on emerging rather than established companies.

While venture capitalists typically work with start-ups, in fact this type of funding can apply to businesses at any stage of development. In many cases, venture capital firms specialise in a specific sector or type of business.

The benefits of venture capital

Ideally, venture capital funding offers a symbiotic relationship between investor and entrepreneur. There are benefits to both sides of the investment equation.

1. Benefits for investors

Venture capitalists invest their money at high risk in the hopes of generating significant profit. They exchange funding for a percentage of ownership, and if the company performs well, everyone benefits.

2. Benefits for businesses

The most obvious benefit is a source of funding to help grow your business, but venture capital investing can also offer additional infrastructure. Venture capital firms offer resources like recruiters, marketing teams, and in-house technology to get your business off the ground. They can also offer strategic introductions to potential partners, while providing training to grow your market knowledge.

The stages of venture capital

There are several different potential stages of venture capitalist funding to consider. The stage that your business is at will determine the type of funding and additional support offered.

1. Pre-seed and seed funding

At these early stages, funding is used to support market research, product development, and preliminary activities. Your business might still be at the prototype level, without a fully formed idea of what your business will look like. Angel investors and individual donors are the most likely to provide capital – typically between $100,000 and $250,000 for pre-seed stages and $1 million to $2 million for seed funding.

2. Series A funding

Some start-ups skip the pre-seed stage and go straight to Series A funding. However, this second level of venture capital is generally reserved for businesses that are able to prove the ability to scale up and generate returns quickly. It also helps if you have a proven track record of success within your industry, possibly with another start-up. Series A funding usually falls within the $2 million to $15 million range, provided by venture capital firms rather than individual investors.

3. Series B funding

At the Series B level, a business has already passed through the hoops of development and is moving on to expansion. To quality for this round of funding, you should be actively targeting a new audience after a successful product launch. You’re ready to take on established competitors and investors believe you have the ability to do so. At this level, venture capital can range from $7 million to $20 million, also involving established firms. 

4. Series C funding

At this final stage of venture capital investment, your investors see your business as a safe bet with little risk. Original investors have already seen positive returns and you’re tipped to be a long-term success. Funding’s still needed for wider expansion and further product development. You might even be interested in acquisitions and mergers at this level. Your business valuation is based on verifiable data by Series C, so groups like investment banks and private equity firms will now be interested in funding.

As you can see, a venture capital fund can take you right from a pre-seed of an idea all the way up to signing acquisition paperwork. It’s important to find the right fit whether you’re working with angel investors or an established firm, so be sure to do your research before giving away any equity.

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