Throughout history, millions of Americans have found wealth and purpose by bringing their innovative ideas to market. However, most burgeoning small business owners lack the resources, assets and track records needed to secure the funding through traditional means. Thankfully, the country’s thriving venture capitalist community offers inexperienced entrepreneurs the support they need. However, to get that support, founders need to understand three key aspects of venture capital funding.
The difference between debt and equity
When a bank gives an entrepreneur a small business loan, the bank’s only interest is to see a return on their financial investment. When an investor provides a founder with funds, their expectations are usually much greater. Typically, in exchange for an infusion of cash, a venture capitalist will demand an ownership stake in the company with board participation. Venture capitalists want equity because they’re looking for a significant return on their money, not a modest short-term profit. The only way they’ll achieve that objective is by taking an active role in helping a fledgling company realize its full potential. So in addition to their money, nascent businesses will also benefit from venture capitalists’ knowledge, connections and business acumen.
Knowing how much money a company needs
Before taking the plunge into the world of venture capital, an owner needs to know how much money they really need. As this Huffington Post article explains, owners need to account for several factors. They include a detailed understanding of the market they want to break into, a realistic valuation of the company, and a projection of startup, extended operating costs and a financial cushion for the company’s unprofitable brand building phase. Coming to a venture capitalist with a pitch for an investment that won’t let a company achieve its goals is a great way to get a fast no.
How venture capital funding works
While there is no universal venture capital funding procedure, the process generally breaks down into four steps. The most difficult step is to make contact with a potential investor. As this Harvard Business Review article points out, less than one percent of U.S. companies have secured funding from a venture capitalist. Typically these wealthy individuals have found previous success in one particular high-growth field, and tend to invest in companies that operate in the industry they learn about through their professional and personal networks.
Founders will then make a presentation to a venture capitalist, outlining their business plan. The venture capitalist then performs their due diligence, and if they want to invest, will present the founder with a term sheet that describes their investment conditions. After thoroughly reviewing and agreeing to those conditions, the company will then receive funding, usually in intervals based on benchmark achievement. Finally, after an average of four to six years later, the venture capitalist will leave the company by selling its equity.
This article was written by Mario McKellop for CBS Small Business Pulse