A Newbie’s Guide to Venture Capital: Understanding VCs

Written by: Milawe • Edited by: Michele McDonough
Updated May 23, 2011 • Related Guides: Small Businesses | Financing

What is venture capital? Find out what VCs are and what they can do for small businesses. Learning about venture capital and different venues for financing is vital to growth in some small businesses.

An Introduction to Venture Capital

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The realm of venture capitalists can be extremely daunting and mysterious for small business owners, many of which may never enter the realm of obtaining outside financing. By their very natures, venture capital firms and venture capitalists are not afraid of risk. They are very used to risking their money, but they do in a very controlled fashion. Venture capitalists believe in controlled risk, so they will expect you to know your industry extremely well. In addition, most venture capitalists invest in the people running the company more than the product. Management is incredibly important. Venture capitalists are willing to take high risks but only if they believe they can have high returns.

Venture capital occurs in many forms. The most common is simply a group of investors with lots of liquid assets who come together to form an investment firm. In other instances, a firm will raise capital from banks and high net-worth individuals. These venture capital firms are interested in an extremely high return from the companies that they decide to back. Thus, they often look at biotechnology and high-technology industries. Some firms specialize in their investments and will not invest outside of their space.

Types of Investments

Investments are broken into three stages, and each of these has its own sub-stages. While these stages are defined, firms may combine some. It is more important for the person seeking investment to know where they stand than for the VC firms to run by these specific definitions:

Early Stage Investments
Expansion Capital
Acquisition/Buyout Capital

Early stage investment is where most small businesses will begin to seek venture capital. Owners must understand that not all companies should seek VC, because most VC firms expect a high rate of return. For example, if a business owner feels that he or she needs $500,000 to make $1 million, investors will likely not be interested in that type of profit. At that point, seeking grants or a small business loan may be a better option.

Early Stage Investments

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Angel investors: This is also often known as seed money. Usually a low amount of money, this type of investing is used to bring an idea to life. Usually less than $50,000, seed money is often used to create a working prototype of a physical object. Seed money is also sometime used to do initial research to discover whether or not the business is viable. Basically, angel investors will invest to see if a good idea is as good as it sounds.

Start-up: Start-up capital are funds used to actually bring the company into operation. This money is used to set up the company and get it started.

First Stage: This stage refers to the funds used between the starting up the company and starting production of products. Some firms may combine start-up and first-stage financing.

Expansion Capital

Second-Round: This is additional capital injected into a company that has already started production but has yet to turn a profit. Second-round funding provides additional capital.

Mezzanine financing: Also known as third-round financing, this stage is for expansion of an already profitable company. There is usually a minimum about of money that a company needs to be making before VCs will provide this kind of financing. So, small profits in a small company would not qualify for mezzanine financing.

Bridging financing: Bridging financing is typically used to aid profitable companies through a time gap that usually involves a major expansion. This type of funding is very typical when a company is on the verge of “going public”. Bridge financing allows the company to carry on active operations while waiting for a funding event, like issuing an IPO.

Acquisition/Buyout Capital

This type of financing is used specifically to acquire assets for the financed organization and may include the purchase of other companies. This type of financing often runs in the high millions, and it can provide a measure of safety for investment firms as they can sell off assets to recoup losses should the venture fail in their eyes.

Conclusion

Understanding the basics of venture capital is the first step in what can be an extremely difficult path towards outside funding. The number one rule to learn about approaching the VC world is that nothing happens quickly. Patience is a must as is persistence, and never move forward without thoroughly researching what obtaining venture capital can mean to a company.