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Frequently Asked Questions about Venture Capital
What is Venture Capital?
Venture capital is a type of financing that investors provide to startup companies and small businesses that have high growth potential. These companies are not eligible for traditional bank lending, threaten established products and services, and typically require five years or more to reach maturity.
Investments come from investment banks, financial institutions, and accredited investors in the form of money, technology, or managerial expertise. These long-term investments are risky for investors, but the rewards are attractive if the company performs well.
A venture capital firm evaluates a company based on its ideas and products, the management team's background and expertise, and the market opportunity. In exchange for its investment, the investor will receive stock in the company. In some cases, the investor will also receive a seat on the board. This relationship brings investors and entrepreneurs together to grow a company toward a defined exit strategy.
Venture capital investments are an infusion of equity and expertise into startups and small businesses that have big growth potential.
Private equity investments fund companies through debt, equity, or a combination of the two. Companies of all sizes may be bought with private equity. In some cases, private equity funding takes a publicly traded company "private" and delists it from a stock exchange.
A venture capital firm collects money from investors for the purpose of investing in high-growth businesses. The firm makes decisions on behalf of its investors about which companies to invest in according to specific criteria. For example, a firm may focus its investments solely in telecommunications companies.
The Canadian Venture Capital and Private Equity Association (CVCA) lists over 270 corporate member firms and more than 1,800 individual members. According to the National Venture Capital Association, there are approximately 1,000 active venture capital firms in the U.S. Plus, there are many others around the world.
In 2018, venture capitalists invested $254 billion globally into approximately 18,000 startups. This is a 46 per cent increase from results in 2017. Of this amount, $2.9 billion was invested in Canada.
Venture capital firms get paid in two ways: management fees and carried interest. Each venture capital fund pays management fees to the venture capital firm to cover organizational and fund expenses. Management fees are typically two per cent to 2.5 per cent of the capital commitments to the fund. Carried interest is the share of the company’s profits that belong to the venture capital firm. Usually, 20 per cent to 25 per cent of the profits go to the firm, while investors receive the remaining 75 per cent to 80 per cent.
A venture capital fund is an investment fund run by venture capitalists on behalf of investors. Venture capital funds invest in a portfolio of companies with strong growth potential. These investments are high risk, but have the potential for a high reward.
In addition to providing capital, venture capitalists often provide additional value to assist the company in meeting its goals. For example, venture capitalists may offer technological or management expertise or provide industry connections to potential clients or suppliers.
A typical venture capital fund has a lifespan of 10 years. At the end of this period, the fund liquidates and money returns to investors.
When your business is ready for venture capital, create a targeted list of venture capital firms you want to work with. Firms focus on a variety of industries, so make sure to select a firm that specializes in your particular industry. Compare the firm's investment criteria to see if it matches the stage your company is in.
As you narrow down your choices, review prior deals on the venture capital firm's website. Venture capital firms are transparent about their ideal investment opportunities. Pay close attention so you don't waste their time or yours when applying for funding.
Some venture capital firms specialize in certain geographies. If you're located in Vancouver, but all of their prior deals are in Toronto, you may not be a good fit.
Once you've narrowed down your list of potential venture capitalists, it is time to make a connection. Explore your network to seek out a warm introduction. Industry conferences, trade shows, your customers and suppliers, and LinkedIn are great channels to explore potential venture capital partners.
If that fails, send a personalized email through the firm's website. Remember that venture capitalists receive many inquiries every day, so be clear and concise in discussing your opportunity.
Becoming a venture capitalist takes education, industry experience, and money. Ideally, you start with a business degree to learn the fundamentals of a company's financial statements and economics. Experience in the industry you want to invest in will help you understand trends, competition, and opportunities.
When you are ready to invest, having a mentor will help you understand the venture capital process. This person can act as a sounding board as you work through deals and gain hands-on experience.
Working for a venture capital or investment banking firm is another option to gain experience. You'll learn how it evaluates opportunities and structures deals to increase success and protect its capital.
Some venture capitalists start slowly by investing smaller amounts as an angel investor. These early-stage companies also have risks and rewards similar to venture capital, but on a smaller scale.
When you accept money from an equity investor, you give up a portion of ownership and control of your company. This means the investor now also has a say in how you run your business and in its direction, too.
For this reason, some business owners prefer debt over equity funding. With debt, you pay interest on borrowed money, which can reduce cash flow, but you remain in complete control of your company.
It’s hard to track down statistics about venture capital investment failure rates. An article called “323 Startup Failure Post-Mortems” from CB Insights states, “70 per cent of upstart tech companies fail — usually around 20 months after first raising financing (with around $1.3M in total funding closed).”
According to an older Harvard Business School study, of more than 2,000 U.S. companies that received by venture-backed funding, about 75 per cent of them failed.
This study's author, Shikhar Ghosh, explains that there are different definitions of failure. About 30 to 40 per cent of venture-backed companies liquidate, with investors losing their entire investment. On the other end of the spectrum, more than 95 per cent of startups fail to meet the expected return on investment.