Many people know about the excitement and turmoil of the entrepreneur’s journey in raising money for their business. However, not many people know exactly how it works. For that reason, I want to lay out the basics of venture capital.
Every business starts with seed funding. This is the initial money used to start the business. It can come from friends and family, or angel investors. Whatever the source, the purpose of seed funding is to translate that initial dream of a business into a living entity.
For some, this might be enough. They have an existing business and they are content with keeping it running as is. The majority, however, aim to follow the traditional entrepreneur route of harvesting their business, which is where the big money is made. The only two ways to harvest a business is through taking it public with an Initial Public Offering (IPO) or having it bought.
To get the business to a state where it can be harvested it needs to grow. This happens through venture capital, which is essentially infusions of cash used to increase the size and valuation of a business (the present and future monetary value). Typically this happens in three rounds: A round, B round, and C round, though there can be more (e.g. Uber). The cash from each round is used until it runs out and hopefully, the business will be in a good position to do the next round.
The reason entrepreneurs rely on venture capitalists and not banks is twofold. Firstly, venture capitalists take a long view of investing (5 years +) which is suited towards growing businesses. Secondly, banks have the ability to seize all business assets if a payment is due, and they will not hesitate to do so.
But who are venture capitalists? Mostly they are high net worth individuals and firms that supply money as an investment. They purchase percentages of your business and become limited partners, meaning they benefit from the financial success but have no say in how the business is run (in theory if not practice).
Ideally, both the entrepreneurs and venture capitalists in partnership make it to the IPO or sale of the businesses and everyone is happy. More often than not, though, businesses stagnate or flop. That is why above all other considerations venture capitalists look for in a new startup, it is how experienced and capable the management team is, for while a shiny business model and a flashy product are all well and good, it is the leadership that will make the difference when the inevitable storms of challenge hit.