If you’re thinking of launching a startup, you’re probably looking into potential funding streams, and you may have come across venture capital. Often referred to as VC, venture capital is a funding option, which involves investment from a venture capital firm. These companies, which are driven by individuals looking to capitalise on innovative ideas and entrepreneurial flair, often have an interest in startups, supporting them through the early stages to the point where goods or services become available to the public. If you’re new to venture capital, or you’re unsure whether it’s a viable option for your business, here’s an informative guide to how venture capital works.

How VC Firms Are Structured

Venture capital firms tend to have a structure in place, with individuals taking on clearly defined roles. Analysts are the most junior members of staff, and they are often graduates or college interns. The primary job for an analyst is to sniff out potential opportunities by attending events like conferences. An analyst won’t decide whether or not to invest in a fledgling business, but they can set the wheels in motion. Associates occupy the next rung up. Associates usually have excellent communication skills, and they’re often involved in forming relationships and paving the way for budding entrepreneurs to meet more senior members of the VC firm.

Principals are more senior members of staff. Although they don’t have an integral role to play in determining an overall strategy for investments, they are able to make decisions, and they can have a great deal of influence when it comes to choosing where to invest money. At the top of the tree, you’ll find partners. Partners can specialise in investment or operational decisions, or undertake both roles. While partners are not usually heavily involved in the day to day running of the firm, they have the final say.

Some VC firms also appoint an entrepreneur in residence or an EIR. These individuals tend to take up short-term employment opportunities, analysing deals and attempting to spot successful startup opportunities.

What happens when you get funded by a venture capital firm?

Securing venture capital funding requires you to go through a process, which works as follows:

  • Identify suitable targets: the first step is to identify relevant targets that are investing in areas that are relevant to your startup. There are several tools you can use, for example, Crunchbase and CB Insights. Create a list of potential targets.
  • Identify contacts: once you have a list of firms in front of you, make use of your contacts, and see if you have links with anyone who could get you an introduction.
  • Organise a call: the first point of contact will usually be a call, which will provide an opportunity to speak about the project in more detail, and hopefully, leave the VC wanting to know more. If the call goes well, the next step is a pitch deck, or presentation.
  • Send your presentation: if you’ve been asked to send over a presentation, check it several times before you hit the send button, and make sure it showcases your business in the best light. If the pitch deck impresses, you may be invited to meet a partner face-to-face.
  • Face-to-face meetings: a face-to-face meeting offers a chance for the partner to get to know you better, find out what makes you tick, and discover more about your business. Be prepared to be asked several questions and to be challenged on your ideas.
  • Partners meeting: the final stage is usually a meeting with all the partners. At this point, any final concerns will be raised and discussed, and you may be offered a term sheet. This is not a legally binding agreement, but it’s a very positive sign.
  • Due diligence: if you have a term sheet, the process of due diligence will commence shortly after. This usually takes between 1 and 3 months and should culminate in the release of funds, provided there are no unexpected issues.

Usually, it takes around 6 months to go from an initial introduction to securing VC funding.

How do venture capital firms make money?

Venture capital firms are known for giving out money, but how do they boost their profits and generate an income? VCs make money through various channels. Firms charge management fees, which generate capital, and they also benefit from interest. Typically, management fees are set at around 2%, while carried interest rates are usually 20%-25%. Carried interest is a charge on profits.

To receive a carried interest payment, the VC monitors the portfolios of funds that are due to exit. This represents firms that are being acquired or those going through IPO with investors preparing to sell. It usually takes 5-7 years for a business to exit, but timeframes can vary hugely. Most VCs aim to sell within 10 years.

Startups represent a high-risk investment for venture capital firms, as failure rates are alarmingly high. With around 90% folding, VCs tread cautiously with new businesses. Often, VCs will aim to back companies that have the potential to achieve a 10X return to cover losses of other ventures within the portfolio. If you’re launching a startup, and your numbers fall short of this kind of figure, it may be advisable to explore other funding avenues.

Relationships between VCs and companies

If you’re thinking about trying to get an introduction and secure VC funding, it’s natural to wonder how much involvement a venture capital firm will have in your business going forward. Some VCs may have a different approach, but most will want to be actively involved in the company. In most cases, a VC will buy equity worth in the region of 15%-45%. If there is a high stake, which tends to be commonplace when investing in new businesses, the VC will want to be involved in board decisions. There are two levels of board involvement: one relates to taking part in decision-making, and the other is an observatory role. An observer will be free to attend meetings, but they won’t have the power to vote. Despite this, they are still likely to have a great deal of influence around the table.

What are the benefits of working with a VC?

Many aspiring entrepreneurs will hurtle towards a VC dreaming of drafting in a team of individuals, which is capable of catapulting them to the big time. In truth, this is not always what happens, and it is wise to proceed with caution when exploring this option as a funding stream for your startup. While venture capital firms can bring a lot to the table in terms of helping you develop and deliver a strategy, you’ll need to conduct due diligence to ascertain just how helpful they will be in terms of capital and growth.

One of the most significant benefits of VC funding is introductions. It can be tough for new faces in the world of business to get that foot in the door, and the people you meet as you go through the process of trying to secure funding will undoubtedly have an expansive network of contacts. Using these contacts, you could benefit from meeting more people and from introductions that carry more gravitas and weight.

Another potential benefit is the infrastructure that you could possibly gain access to if you receive VC funding. Many firms have established, dedicated departments and teams, which are designed to optimise growth, for example, marketing and recruitment.

Is VC right for you?

To decide if VC funding is right for you, it’s wise to ask a lot of questions and to gather as much information as possible before you make a decision. Look at the track record of the VC, browse the portfolio with an eager eye, and see how many companies reach the next step. If a VC has a record for investing for less than 6 or 12 months, this indicates that they are having difficulty closing the next phase, for example. It’s also useful to raise queries about how the VC works with portfolio firms and to see if you can get an introduction to company owners whose ventures have failed. This will give you an insight from the other side, and provide a more rounded viewpoint. It’s also beneficial to ask questions related to your team and how recruitment will work in the future. If a VC expresses an interest in replacing the existing team, this may make you think twice.

The uptake rate for VCs is very low. Typically, out over every 1,000 companies, a VC will invest in 3 or 4.

What is the difference between VC and private equity?

Venture capitals are different to private equity firms. VCs tend to work with businesses throughout their life cycle, and they usually like to be involved in operations. VCs also take on riskier projects that private equity investors. Private equity firms prefer to take on more established firms and focus on growth.

Venture capital firms invest in new businesses and startups with a view to generating an income through management and carried interest fees. While there are benefits of VC funding for startups, opportunities are sparse, and this is not always the best option for every aspiring entrepreneur.