How Venture Capital Works

Written by Blake on . Posted in Get Funding

In order to start up your own business, you need money. You need money for the space. You need money for furniture. You need even more money for equipment, advertising, supplies, and employees. The list goes on and on. And for a new entrepreneur, the list may seem a bit overwhelming. How do new entrepreneurs afford all of these startup expenses?


Some entrepreneurs bootstrap by using their own checking and savings accounts to pay for startup expenses. Others obtain bank loans. Yet, others use something called venture capitalists, or VCs; an important way to obtain large amounts of money to help a business pay for start-up expenses.


The way that VCs work may seem a little confusing at first glance. The process is quite simple and a very smooth way to raise capital for your startup business. Venture capital works in five different steps.


Step 1: Develop a plan
Most venture capitalists look for a business plan. However, you do not want to spend months and months on an overly-detailed business plan. Instead, prepare a list for your future VC on how fast you think your company will go, how much money it is estimated to make, etc. If the VC likes your overall plan, they will invest money in your company

 


Step 2: Seed Round
If the VC likes where your business plan is headed, they will invest. This first round of money is called the seed round. Anticipate three to four more rounds of funding before the investments of your company "go public". Additionally, your company needs to repay the VC for taking interest in the new business. Therefore, your company should give the VCs stock and some control over the decision that the company makes.

 


In order to decide how much stock a VC should get in return for the money it invests, your company and the VC need to make a pre-money valuation. A pre-money valuation is made when the VC firm and the people in your company agree on how much your company is actually worth. Later on, the VC firm invests the money in what is known as a post-money valuation.


Step 3: Opening a Fund
If your company needs a bigger pool of money to start-up, a VC will open a fund to invest in. This is a fixed amount of money. This pool of money (let's say, for $1 million), can come from wealthy individuals, various companies, and pension funds. All of the firms and funds that are involved have a specific investment profile.


Step 4: Liquidation
The VC firm will then invest the entire pool of money (in our case, $1 million) and anticipate that the investments it made will liquidate anywhere from three to seven years. Liquidation means that each of the companies it invested in will "go public" or will be bought by another company. "Going public" means that the company will sell shares in a stock exchange. Once liquidation happens, the VC firm cashes out and places the proceeds back into the fund.


Step 5: The Outcome
By the end of your VC venture, you should have more money that the $1 million that was originally invested. The fund is then distributed back to investors based on how much each one contributed from the start. Most investors look for a 20% per year return on investment for the fund. Not only will you have enough money for your startup expenses, but you will also have built credibility with many other companies as well as a VC firm.