How Venture Capital Works

A venture capital investment is inherently risky. It can occur well before a company goes public and without an established track record (especially at the earliest stages). Therefore, the possibility of significant losses — even the entire investment — is factored into a VC’s business model.

Unbelievably, most VCs anticipate that they’ll lose money on most investments.

The odds of hitting a “home run” (earning over 10X) are small and can take years to realize.

The key to a VC’s calculation is that a few of their very successful companies can pay dividends that far offset the losses.

Venture capital is a journey with distinct stages

While there are many sources of Venture Capital (and nontraditional investors are rapidly joining the mix), venture capital generally comes to life over three main stages:

1. Pre-seed stage: Modest early-stage funding typically for product development, market research, or business plan development.

2. Seed stage: Money supporting growth during a startup’s first expansion phase.

3. Late-stage: Funding for more mature companies that have proven rapid growth, generate revenue, and sometimes profits.

Also, many VCs target a specific industry or sector, geography, or stage of company development. This is an essential factor in a startup’s life stage, business model, mission, and long-term vision.

Funding is not the only advantage of venture capital

While fundraising is chief among the benefits of working with a venture capital firm, there are plenty of other advantages:

• Expansion capability — If a startup has high initial costs and limited operating history but significant potential, venture capitalists are more likely to share the risk and provide the resources for success.
• Mentoring — In addition to funding, venture capitalists are a valuable source of guidance, expertise, and consultation.
• Networks and connections — Venture capitalists typically have a vast network of contacts in the innovation community.
• No repayment — If a startup should fail, that company may not be obligated to repay venture capitalists (unlike loans requiring a personal guarantee).
• Confidence — VCs are regulated by the SEC, and their financing mechanisms are subject to similar regulations as private securities investments.

How to know when venture capital is right for your startup

Whether a startup needs VC funding depends on the nature of its business. If a startup requires heavy upfront investment — manufacturing facilities or a large sales force, for example — or will take years to realize commercialization and revenue — which is the case for some life science companies — seeking VC funding may be critical.

It’s worth mentioning that there are plenty of successful startups that never sought VC funds. In fact, only a small percentage of startups raise venture capital. Other funding alternatives can include commercial loans and debt vehicles, venture debt in conjunction with Series A to reduce dilution, licensing deals, and partnerships with corporations. Some startups with low initial costs, like software, can even get started with founder funding (i.e., bootstrap) and scale using the proceeds from sales.

The takeaway: Go with what fits your mission and vision

Like any critical decision associated with an early-stage startup, understanding the spectrum of funding choices will affect a startup in both the short and long terms. Choosing the course that best aligns with a startup’s mission and vision is the best way to go.