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- Private capital investments in private enterprises, (i.e., businesses not listed on the stock exchange), are known as venture capital investments. It's similar to private equity (PE) but, at the same time, a little different from it as well. Venture capital lends money to startups that are extremely early in their lifecycle, whereas PE invests in startups that are in their later stages of development.
- Rich families, retirement funds, insurance firms, and other financial institutions with substantial sums of money could be among a VC firm’s limited partners. They give the funds to the venture capital firm which then invests the money in new and promising startups. However, LPs (limited partners) are not in charge of the VC business (thus, the use of the word "limited").
- General partners are usually experienced financial advisers with a concrete track record of managing funds. They are involved in the investment processes at nearly all levels -- from pursuing limited partners on behalf of a VC firm, then deciding which companies to invest in, then helping those portfolio companies grow and, finally, acting on an appropriate exit strategy to generate profits for the limited partners and the VC firm.
- VCs have several tools at hand to boost the value of their portfolio companies. They can offer cash, brand value, intra-industry networking, funding networking, and an array of in-house resources that most startups are in need of.
- There are many benefits to working with venture capitalists. The money belongs to the startup (with no burden of repayment), the funding is frequently accompanied by assistance that goes beyond money (as explained above), there are great opportunities for networking, and a newfound scope for rapid expansion (if needed).
Private capital investments in private enterprises, (i.e., businesses not listed on the stock exchange), are known as venture capital investments.
It's similar to private equity (PE) but, at the same time, a little different from it as well. Venture capital lends money to startups that are extremely early in their lifecycle, whereas PE invests in more mature startups. The emphasis on early-stage startups (higher risk) is what gives VC its name. However, it is not wrong to say that VC is fundamentally a subset of PE.
How Does Venture Capital Work?
Rich families, retirement funds, insurance firms, and other financial institutions with substantial sums of money could be among a VC firm’s limited partners. They give the funds to the venture capital firm which then invests the money in a startup. However, LPs (limited partners) are not in charge of the VC business (thus, the use of the word "limited"). They are prepared to invest in a VC firm because of the higher predicted returns compared to their other possibilities (public equity markets, debt, real estate, etc.). With that said, they also recognize that it is a high-risk investment and, therefore, commit just a tiny portion of their funds to it (usually 5-10%).
General partners (GPs) are usually experienced financial advisers with a concrete track record of managing funds. They have to juggle many responsibilities:
- Fundraising: GPs approach LPs and propose the investment idea to them in order to raise funds (they also sometimes submit a pitch deck like startup founders do) and, if things go well, they are able to get money from the LPs.
- Invest: GPs must find companies (VCs refer to this as "Deal Flow"), assess them ("Due Diligence"), and then finally invest in them (disburse the funds).
- Grow: After having invested in startups, general partners assist them in their growth by providing whatever resources that they can. This might include devising strategy, finding talent, making introductions to possible partners, or even finding investors for the next round of funding.
- Exit: The GPs can either try to go public with the company (IPO), sell it to another company (M&A), or sell it to another investor (“secondary sale”). That's how they generate profits, which they then give back to the LPs.
Many venture capitalists assert that their investments add value to the startups they finance. But how do they manage to achieve this? And is it truly resulting in higher returns for their investors? Several venture capital firms are focusing on hiring more employees with an operational skillset. It is widely believed that most funds with well-developed portfolio operator systems have top-quartile yields, based on a variety of sources (generally above 20% IRR in the relevant timespans).
There are five key tools that VCs can employ to boost the value of their portfolio companies. These are:
- Industry network
- Finance network
- In-house experience
A competent operational toolset is costly.
This is where VCs come to the rescue. After all, money is often the first and foremost reason why founders embark on their fundraising journey in the first place. In line with this, VCs proactively finance entrepreneurial ventures, assisting cash-strapped early-stage startups with their product development, growth, and expansion at an unprecedented pace.
Startups, by definition, do not have competitive brand value when they embark on their journey.
This is why the mere fact that a startup has been sponsored by a well-known fund/partner might boost its chances of success. Such an improvement to the startup's brand makes it easier to attract exceptional team members and follow-on investors.
Networking within the industry
The default response of some of America's most notable VCs to all challenges is to email-connect founders to 3-10 individuals in their networks who could help.
Later-stage venture capitalists pay close attention to the previous investors in a startup, utilizing the investors' image and reputation as a proxy for their own due diligence. As a result, the next best asset to having a substantial war chest is the capacity to readily raise more cash the second and/or third rounds from a VC’s former syndicate partners. This is why the funding network that VCs provide access to can prove to be of utmost importance to the startup’s future.
Pros of Working with Venture Capitalists
The money's all yours now
VC firms rely on the potential of your future success to make their money.
Instead of providing you a loan that you must repay later, VCs trade in their money for a share of your startup in the hopes of benefitting from its future success. This implies that when you're attempting to scale, you won't be burdened by crushing debt and the drag of monthly payments. You have great control over the money that VCs invest in you.
Frequently accompanied by further assistance
VCs have a strong interest in your startup's success since they want to earn a profit on their investment. This implies they'll do whatever they can (within reasonable limits) to assist your startup in growing and developing -- using proven tactics.
As a result, expert guidance, mentorship, and training are typically included in the investment deal.
Provides chances for networking
VC investors wouldn't be where they're at if they weren't well-connected: and that is part of the appeal of bringing them on board.
They not only know different investors, but they often get to meet a lot of other companies and people who have the talents and resources that you'll likely need. They can generally guide you in the right direction, whether you're searching for partners, cofounders, staff, consultants, or more money.
Allows for rapid expansion
If you're ready to expand but find the process too long, slow, or/and grueling, venture capital investment may be the answer. Because of the financial resources that VCs provide, startups may develop and expand considerably more swiftly than they could normally; such speed and momentum are crucial in today's fast-paced market.
As a result, startups with growth-enabling VC capital have a distinct edge over competitors.
The Art of Warm Introductions
Here’s the deal.
Investors are not keen on meeting you. They want you to be introduced to them. There's a significant difference between the two approaches -- and it's only logical. A venture capitalist's job is to locate the needle in the haystack. As a result, investors depend on their network to conduct the first screening.
This nugget of knowledge should certainly be incorporated in the way you go about soliciting funds. Instead of aiming to establish an investor network, you should first focus on building an introducer network. And not every introducer is the same.
Here are four suggestions to assist you:
Your Friends’ Investors
You almost certainly have friends (or at least acquaintances) who are developing their own startups if you work in a startup hotspot. Request their assistance. "Am I ready to fundraise?" should be your first concern. This question will help you determine how warm the introductions that your friends might make for you will be. If they like you but don't completely trust your startup yet, they won't be able to disguise their feelings from their own investors. However, once you've received their approval, you should definitely ask them for potential introductions.
Founders Who Aren’t Friends
Securing a meeting with another founder is considerably easier than getting a meeting with a renowned venture capitalist. When asking another founder for an introduction, you must make a strong case for your startup, since a founder will only make an introduction to their investors if they feel that there is a good chance that the introduction will culminate in an investment. (When it doesn't, it has an impact on the entrepreneur's own reputation.)
You need to start to transform your early investors into your champions as soon as their investment arrives. They'll likely become your most reliable source of warm introductions. However, you must assist them in being helpful since they have no idea who you've already spoken to or exactly how you need assistance. Be empathetic and communicate effectively with them.
A well-organized investment pipeline is extremely helpful.
It's where founders keep a record of every investor they've approached. This record should track not just your position with each VC but also which contacts you share with them. Make an effort to balance things out so that the people who can offer the greatest introductions are dispersed fairly equally. Getting three introductions is great, but getting five is definitely stretching it, except if the introducer is a good friend or an investor themselves.
Introduce Potential Customers/Partners/Employees
Just because someone has asked you to connect them with a VC isn't a good enough reason to actually do so. Consider whether the two individuals are a good match. If somebody you know has a "concept" and asks you for a connection to a particular VC, and you understand that the VC doesn't invest in "concepts," tell them you'd be delighted to make the introduction later, once they've progressed beyond the "concept" stage. Remember to clarify why the introduction might be premature. You should also feel free to inquire as to why the individual requesting an introduction wants one and whether they think that they are ready for being connected.
If you want to introduce your own employees or business partners to a VC, the latter should be able to have trust in your team's ability to build your business. You might not have enough time to go into considerable detail about why all 10 (or even more) members of your team are perfectly qualified to help your business flourish (if you have a team that large). Pick five individuals to focus on and talk about; these five people might be cofounders, employees, or advisors.
Identify one outstanding accomplishment the individual has achieved that makes them stand out as a valuable team member of your startup. Do this for each of the five people. Include the rest of the founding team on the slide to illustrate the size of the team but don't spend too much time talking about them.
Founders with little or no operational expertise and insufficient money might use venture capital to raise money and receive advice from experienced industry professionals. Due to their general lack of business expertise and the high-risk nature of new startups, founders frequently are unable to obtain bank financing, which is where venture capitalists step in. Venture capitalists offer money to founders in return for proportionate decision-making authority and an equity stake in the startup.
Learn more with us
- How to raise capital?
- A guide to startup venture capital funding
- Pitch deck for venture capital
- Should I hire a startup fundraising consultant?
- Learn more about fundraising and venture capital
Access more guides in our Knowledge Base for Startups.
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