Venture capital, also abbreviated as â€śVCâ€ť, is a sub-set of private equity, and refers to institutional investments in early-stage, high-potential growth companies.
And in this context, â€śinstitutionalâ€ť means that venture capitalists are NOT investing their own money, like â€śangelâ€ť investors do. Instead, they are investing money on behalf of institutions, such as pension funds and university endowments (as well as the collective funds of some very wealthy individuals).
Because they are utilizing other people's money, and are judged and compensated by the performance of their investments, venture capitalists are extremely rigorous in their investment decision-making process.
VCs have several criteria that they use in their investment decision-making process:
Scalability: venture capitalists primarily look for companies that can grow really fast with an infusion of capital. Thatâ€™s why technology companies are favored by most VCs.
Management team: VCs look for a quality management team. In fact, many VCs say they rather bet on the jockey (i.e., the management team) than the horse (i.e., the companyâ€™s products and/or services).
Market sector: Many venture capitalists only invest in specific sectors such as healthcare or software. You need to check the venture capitalistsâ€™ website to understand their sector focus before contacting them.
Market stage: some VCs like to invest in companies very early, while others require the company to already be generating revenues. You need to check the venture capitalistsâ€™ website to understand their market stage focus before contacting them.
Significant market potential: VCs tend to invest in companies with significant market potential of $50 million, $100 million or more. This is because even with all their relevant experience, the average venture capital firm will lose money on half the companies they invest in and only break even on a third.
This is a key point when seeking venture capital. Where VCs make their money is on the approximately 20% of companies they invest in that see explosive growth and provide remarkable returns of 10 times to 100 times or more on their investment.
Specifically, it is important to note that relatively few venture capital investments produce large gains. In fact, industry insiders sometimes refer to the 2:6:2 rule. This rule is that an average portfolio of ten investments will include two losses (e.g., companies go bankrupt), six moderately performing companies (may break-even on the investment or lose a little) and two very successful returns.
In fact, an analysis by Bygrave and Timmons of VC funding between 1969 and 1985 found that just 6.8% of investments returned ten times or more on the invested capital. Conversely over 60% of investments lost money or failed to exceed the amount of money earned if the capital had been put in an interest-bearing bank account.
The result of this analysis is that typically a venture capitalist will want to see the ability to get 10X their money back or more from investing in your company. As such, if you are seeking $1 million from VCs, you must show them a realistic scenario where you can turn that $1 million into $10 million.
This is key! Even if your company can expect to earn a VC their average return, they will not be interested. You must show them a path to earn 10 times their investment back!
The points above will give you good guidance regarding whether your company qualifies for venture capital, and which VC firm might be a fit for you.
The next step is to begin contacting VCs. One thing to avoid like the plague is sending your business plan to lots of venture capital firms. Itâ€™s sort of like a handing out your business card to anyone who will take it. It makes you look desperate. Also, because VCs talk amongst themselves, if just one VC doesnâ€™t like what they see in your company, it could negatively influence other VCs.
Finally, if your contacting phase goes well, you might move on to arranging meetings, and finally negotiating and consummating the financing transaction.
This article was contributed by Dave Lavinsky, President of Growthink. If you would like to a step-by-step insiderâ€™s guide to raising capital, download Growthinkâ€™s Step-By-Step Guide to Raising Venture Capital.