Dan Lok explains how venture capital works for current businesses and startups
All new businesses need money to help get them off the ground. Unless you are a wealthy individual, you will have to get external funding to make your business succeed. Most startup businesses fund themselves through a combination of personal savings, investment from friends and family, and bank loans, as well as the profits from their own sales.
If you need a large pool of money, you may be interested in looking into venture capital funding. Venture capital firms or VCs are most interested in certain types of business. Technology firms, particularly biotech firms, receive the most venture capital funding. Dan Lok explains what venture capital is and how companies can start the process of receiving it.
What is a venture capital firm?
Venture capital firms start by opening a fund. The fund is the pool of money that the firm uses to invest in other businesses. The firm gets money from a number of sources, including wealthy individuals, pension funds, and companies that wish to invest. When the firm has a big enough fund, they will choose companies in which to invest.
Every venture capital firm has its own investment profile. For example, some funds are looking for biotech firms. Some firms are looking for second-round financing opportunities. Others may be interested in finding companies that are interested in doing an IPO (Initial Public Offering) in the near future. Investors keep track of the risks and rewards of each category, and they have a good understanding of how much money they expect to make back from their investments.
Typically, venture capital firms will invest their entire fund, anticipating that their investments will bear fruit in 3 to 7 years. Venture capital firms expect their proteges to go public or be acquired by another company. The goal is to make more money than the fund invested in the beginning.
Venture capital funding can be risky for an investor. Some companies will fail, and some will stagnate. The reason the business model works is that companies that go public may be worth millions of dollars. Proven venture capital firms will pocket tidy profits most of the time, hoping for a 20 percent annual return on their investments.
How does venture capital funding work?
Venture capital funding is not intended for the earliest stages of a business’s life cycle. It is instead meant for the second stage when the business is getting its innovative product to market. Venture capital money is not intended to be used long-term, but rather to provide an injection of cash in a vital stage of the business’s development.
Venture capital funds exist because there are so many restrictions on bank funding. The type of investment that venture capital funds thrive on would be considered too risky by a bank, which would then charge exorbitant interest rates. Since the banks are not allowed to charge the interest rates that would justify their investment, venture capital steps in to fund these risky firms and make a large return.
In exchange for their cash infusion, venture capital firms receive a controlling ownership stake in the business. This means that they have a strong interest in how the firms work. The popular image of a venture capital firm is that of a fairy godmother that provides both money and a level of hand-holding guidance to their invested firms, but most VC firms are too busy to spend much time on this activity. Sometimes they provide leadership by hiring “virtual CEOs” who can help the leadership team with their daily challenges.
The process of receiving venture capital funding
Companies in fast-growing industries are most likely to seek out venture capital funding in their early stages. In order to qualify for venture capital funding, most companies need:
- A team of founders
- An MVP (Minimum Viable Product)
Venture capital firms need to see disruptive ideas in order to attract investments. Without this level of innovation, it is unlikely that they will put money into a company.
The next thing that a company needs to secure VC funding is a solid pitch deck. Pitch decks are presentations that give an overview of a business. The deck can tell investors about a product, business model, funding needs, market opportunity, and the management team.
One of the key elements of the pitch deck is the “pain point” the company is trying to solve. Without a clear need in the market demonstrated by this pain point, VC firms will not want to invest.
Pitch decks should also introduce the management team and their qualifications, track the company’s progress, explain the company’s financial situation, and lay out how much money they would like to receive from the venture capital firm.
Finding the right venture capital firm to fund the business is the next step. Each venture capital firm has a different focus and pitching to the wrong type of firm will not bear fruit. Firms may concentrate on biotech, software, consumer products, green technologies, or fintech, among other industry sectors. Some VC firms also focus on different levels of company development, from the seed stage on up.
Setting up the deal
Together with the venture capital firm, companies create a term sheet. This is a non-binding listing of the terms that will be required for financing. The VC firm lays out the financial side of the investment, and how much money the company offers to put into the business. They will also spell out what kind of control they want over the business.
Finally, the liquidation section governs what the VC firm expects to happen when the company is dissolved, sold, or liquidated.
Understanding venture capital
Before going into the venture capital process, it is necessary to understand how the industry works. If companies have a good idea of what to expect from each stage of the process, they will be more likely to succeed. Dan Lok encourages businesses to look into VC funding, especially if they fall into one of the preferred industries.