Venture capital is a form of financing that provides risk capital to young, often tech-focused companies. VC focused on a 5-to-10 year time horizon and is intended to provide a company with the resources it needs to grow before going public or being acquired.
Broadly speaking, there are three company stages: Pre-seed, seed, and post-seed. These distinctions are important because they determine the risk-reward balance an investor assumes and how much capital is committed at any given time.
Pre-seed is when a company is conceived. Founders often go into debt to start operations and usually bootstrap for a period of time. The goal during this phase is to prove a sufficient market need for the product or service to justify further investment.
Startups may raise capital from friends and family, or through crowdfunding campaigns in the pre-seed stage. The average pre-seed round is $500,000 for 10% equity, and takes just over 20 weeks to complete.
The process is relatively simple: an entrepreneur presents a business idea to a group of potential investors in an informal setting. They’ll pitch the business, explain how it works and make a case for why to invest. Investors will provide feedback about the business plan and opportunity, as well as discuss any concerns or red flags that come up during this stage. Next, a term sheet is drafted, which outlines what’s expected of both parties moving forward.
Companies generally spend their pre-seed funding on hiring key executives like the CMO or CTO and setting up business operations needed to support scaling operations. This includes things like accounting systems, an office space, acquiring the necessary equipment and staffing up with developers and designers who can begin building out their products or services.
Seed is the first VC-backed stage of a company.
Gaining traction during the seed stage enables the company to prove its market viability and attract further funding in subsequent stages of growth. This allows a team to hire more employees and develop their product or service further.
Seed funding is, on average, just under $1M, typically for 10 to 20% equity. These figures depend on factors like industry vertical and product traction. Seed rounds have been growing dramatically in size, with average seed funding being just $100,000 in 2010.
Seed funding is critical for a company’s first years of operations, allowing them to grow while minimizing financial risk. Once a company has reached an inflection point and achieved sufficient traction, it’ll need to move on to the Series A stage.
Only about 40% of startups that raise a seed or angel round make it to Series A.
The series A round represents the first time that venture capitalists have committed significant sums of money – on average, just over $22M, with an $8M median – into a startup. Startups typically give up 20 to 25% equity. It's a signal that the startup has proven it has a viable solution in a viable market, and shows potential for exponential growth ahead.
This is when entrepreneurs are able to validate their assumptions around market size and customer needs, which should help them narrow their focus on what they do well and where they need to improve before moving onto Series B or C financing rounds. As with all stages in the process, there’s no set timeline in which these stages occur.
The startup may need to pay back part or all of their initial investment from previous stages at this point. Investors are likely to want some form of performance-based milestone, such as an exit event or an IPO within four to nine years, which will be defined up front by the investors based on their experience with other companies they’ve funded.
The question that often arises is whether there is sufficient growth potential post-Series A for VC investors to continue backing the company – and providing it with further capital – before getting what could potentially be a big return on their investment.
The Series A round demonstrates that the startup has reached a certain level of maturity with its product or service offering. If investors believe that the company will be able to continue scaling and gaining market share in its industry, then they may provide additional funds in subsequent rounds.
Post Series A
In many cases, companies will raise multiple series of financing rounds throughout their lifecycle. These additional rounds can go from Series B to Series H, or even beyond. Only 1% of venture-funded companies have raised a Series F, and only 4 companies out of a database of 15,600 raised a Series H.
Depending on how much money a company needs and what stage it’s at in its lifecycle, it might need to fundraise multiple series before conducting an IPO or going the M&A route. Thirty percent of seed-funded companies exit through IPO and M&A, though the latter is more likely.
People invest in venture capital as a diversification play and an absolute return play.
Venture capital strategy involves two parts: Portfolio construction and post-construction activities, including active management, allocating capital in follow-up rounds, working to get exits and so on.
VC investors have a limited amount of capital at their disposal. They have to invest it somewhere, and good VC investors do not want to tie up all their money in few deals. So they spread the risk by diversifying across many different deals (typically 40 to 70).
The more deals an investor has under management, the better diversification they offer and the less chance that the portfolio will tank.
Accelerators are one common way to build a large, diversified venture portfolio. Accelerators play a big role by offering access to investor networks, mentorship, office space and an opportunity to pitch directly to investors at the end of the program.
An accelerator offers fixed-term, cohort-based programs for early stage, growth-driven companies, investing capital in and offering services to these companies in exchange for an equity stake.
Portfolio construction is what makes venture capital different than other forms of investing. That's because VC investments are illiquid: you can't just sell them whenever you want like public stocks. You have to wait for your fund managers to find exit opportunities, which could take months or even years.
This is where active management comes into play: instead of sitting on the sidelines and hoping for returns, active managers look for ways to get exits from their investments via M&A or IPOs.
Passive investing (allocating capital based on market forces instead of taking active roles) does not require as much time and energy from portfolio managers since they are only responsible for monitoring market trends.
Once a deal has been funded, there are still numerous actions that need to be taken in order to complete the investment successfully – which means getting an exit at some point down the road (or in some cases creating value in perpetuity).
These post-construction activities include everything from managing employees, board members and partners to growing revenue streams through acquisitions or partnerships and providing connections. All these activities add up over time and help ensure long-term success – which may eventually lead to an IPO or acquisition by a larger firm.
Research indicates that networks are crucial to generating outsized venture performance relative to peer funds. Startups that benefit from these networks experience higher exit rates, both through IPO and M&A.
Besides serving on the boards they invest in, many venture capitalists stay on board as informal consultants and even hand-pick management. Through their large networks, venture capitalists help find the right talent, which is key to success.
Acquiring other startups
Acquisitions are another way to actively manage a portfolio. By acquiring other companies, VCs can gain customers, revenue streams, and complementary assets that can help a portfolio company grow in new ways. The downside is that when a manager acquires another company, it’s not uncommon for them to operate independently for a period of time while the teams and cultures are integrated.
It’s important to make sure that any acquired team members are happy with their compensation packages and working conditions during the integration phase. This may mean making some changes or providing additional resources where necessary.
Crunchbase reports that startups are acquiring other startups at an unprecedented rate. Just over half of venture-backed U.S. company acquisitions have been by other venture-backed companies in 2021.
Value-add VCs aren’t just about capital; they seek to improve the odds of success at every turn, which includes understanding the portfolio firm’s focal point, identifying opportunities to improve and building a team with the skills to deliver on those opportunities.
The top reasons that startups fail include lacking a market need, stiff competition and having a flawed business model. VCs with a keen eye can spot these problems ahead of time and pivot to avoid failure.
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This opens the world of venture capital investment to everyone. Our approach is simple: We provide access for the masses through a marketplace to search investment opportunities at your fingertips and build an optimized portfolio, while we handle the back-office work.