Financing is the biggest challenge facing entrepreneurs when starting a business. Small business owners in nearly every industry have trouble finding capital to bring their business idea to life. In many instances, getting a loan isn’t the best option. Many entrepreneurs turn to venture capital funds to help get their business off the ground.
Venture capital refers to financing given by well-off investors or investment banks to startups and small businesses that the investors believe have big growth potential. The support or financing from a venture capitalist may not always be in the form of cash; some prefer to provide expertise or management. When a venture capitalist invests in a small business, it is usually done in return for equity or a say in company decisions.
Generally, venture capital funding is applied to high-growth, high-risk companies. If you’re interested in raising venture capital funding, here’s what you need to know to get started.
Evaluate how much your business is worth
Venture capital investors are going to be interested in two main things: the value of your business, and what will their return on investment will be if they choose to invest. Therefore, before you approach an investment bank or venture capital fund, it’s important to know where you stand and what you have to offer.
Valuations involve complicated math, and many venture capitalists will bring in a professional appraiser to help verify the potential of a startup or small business. Generally speaking, however, your company’s worth has to do with the following factors:
- The company’s age.
- The company’s growth rate.
- The senior management team’s experience.
- Revenues and cash flow.
- Patents or other intellectual property.
- Number of users (if applicable).
Before approaching a venture capitalist, do some financial projections to show realistic return on investment. Include any liabilities and equity you’ve already issued; your sales, marketing, and business model; historic revenues; balance sheets and operating budget; and your cost of customer acquisition and customer lifetime value.
Figure out how much you need to raise
You may know you need to raise money, but are you confident you know how much you need? This number is important for your company’s future — the less you raise, the less you need to cede over to a venture capitalist. Venture capitalists will seek to get maximum return on their investment. If they invest $500,000 in your business, they will ask for a smaller stake in your company than if they invest $1 million.
Before you approach a venture capitalist, determine your total needed amount by considering how much capital you can use immediately and effectively, how far along your business is, and how much control you’re willing to give up to new investors. Experts recommend asking for the “minimum investment amount that will get you to your next inflection point that significantly changes the risk profile of your company. This inflection point could be first customers, an annual revenue number, or a new version of your product.” How much you decide to raise will likely become more apparent as you work through your financial projections during the valuation process.
A venture capital deal is typically the stepping stone a business needs to reach the next stage of growth.
Get in touch with a venture capital firm
Where will you find venture capital? Many small business owners perceive venture capital as limited to contestants on “Shark Tank,” and aren’t sure how to locate, let alone approach, a venture capital fund.
A referral from a financial professional — a bank, lawyer, CPA or financial advisor — is usually the best way to go about finding a venture capital investor. Alternately, attend a private equity conference or industry event to begin networking. Many investments from venture capitalists come from building trust and personal relationships over time. Treat each meeting like an opportunity and bring a polished pitch with you to each one.
How to prepare for and pitch the venture capitalist
Before you meet with a venture capitalist, make sure you prepare yourself. Some venture capitalists get thousands of requests for financial assistance each year, so you need to position yourself to define your company’s business model and why it’s unique and worthy of investment.
The key during your presentation is to stick to the facts and keep your pitch concise. Statistics show that an investor spends an average of 3 minutes and 44 seconds reviewing a pitch deck — so treat your initial pitch as step one in a longer courtship.
According to one expert, “You’re really trying to paint the big vision but also provide as much data or as much traction as you can so that not only do they see the vision, but they can believe it can be made.” You should be able to speak about your short-term and long-term visions, the problem you’re solving for your future customers, and why the market is ready for your idea.
What does a venture capitalist deal entail?
A venture capital deal is typically the stepping stone a business needs to reach the next stage of growth. Analysis by Harvard Business Review shows that “more than 80% of the money invested by venture capitalists goes into building the infrastructure required to grow the business—in expense investments (manufacturing, marketing, and sales) and the balance sheet (providing fixed assets and working capital).”
The way the deal is structured will vary slightly based on the opportunity, the needs of the business and the venture capitalist firm’s demands. In general, though, the principle is the same across all venture capital agreements: The investors are looking to protect their investment if something goes wrong, and also maximize their benefit if the company proves to be successful.
For example, a venture capitalist will invest $500,000 in exchange for a 20% ownership position. In the provisions they will have “downside protection,” a safety net that protects the investment if something goes wrong. That can mean they get first claim to the assets and technology, or that the venture capitalist can have voting rights over key decisions. The downside protection provision is something to consider carefully before signing.
How much ownership should you be willing to give up to a venture capitalist?
The answer to this question depends on a few factors:
- Your current ownership structure. Sole proprietors seeking funding have a relatively straightforward offer. However, when you have a team of founders, plus technical experts (engineers, software developers, designers), you may want to offer equity to boost morale and keep your team motivated. As a result, there might be less to offer a venture capitalist when it comes time to raise funding.
- The number of rounds of funding you will need. Venture capital funding is often just the first round of investment in your business. Down the line, you might approach a different financial institution or need to merge with a competitor. Give away too much in the first fundraising round, and you’ll have less leverage for growth down the line.
Experts say a good benchmark is to make sure you retain at least 25% ownership in your own company. That means the other 75% is up for splitting among venture capitalists, other partners and your founding team.
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