Venture capital is an increasingly important type of financing tool for companies in the technology, energy, biotechnology, and other sectors. Venture capital is a type of private equity funding, which is offered by venture capital firms or individual private investors to startups, mid-stage, or emerging companies that have been deemed to have exceptionally high potential for growth or that have shown exceptional growth potential so far. These companies are considered to be in “the know” when it comes to an innovative technology or business idea.
Venture capitalists want to provide seed capital to entrepreneurs who then need to produce profit or return investment to them within a short period of time. Since venture capital firms generally fund businesses based on their own proprietary metrics, there is great debate as to what the appropriate metrics should be in order for a company to raise a significant amount of venture capital. Many venture capitalists believe that a company’s earnings per share (EPS) and market cap should be the metrics that are used in determining venture capital financing. Others prefer to focus on the sales revenue or retained earnings of the company as the better metrics for venture capital funding.
Because venture capitalists typically pool a large amount of capital into these investments, it is essential for entrepreneurs to only give most of their attention to projects that will likely yield a high level of return. This can prove difficult, however, for many new companies due to the extreme level of competition among angel investors. Because the level of competition among angel investors is so high, most entrepreneurs will give more than they think they are worth to get into a portfolio company. In order to increase their value to potential venture capitalists, an initial entrepreneur must also present excellent leadership skills, management skills, and a track record of success.
Companies that apply for venture capital funding should always complete the due diligence process on themselves before approaching an angel investor. In this document, an entrepreneur should include: their business plan, the reasons why they are starting a company, their plans for expansion, their anticipated customer base, the products or services they will be offering, their estimated operating costs, the rate of profit, and their anticipated return on investment. As the venture capitalist reads this document, he or she will be able to determine if the venture capitalist is qualified to invest in the company based on their own personal experiences and due diligence. Due diligence can take months, if not longer, but it is critical that this step be completed when approaching a potential funding source in order to avoid losing money on an unprofitable investment. Additionally, this due diligence gives the future investor a chance to find damaging weaknesses in the application that could result in investors being unable to invest in the company based on personal experience.
While most experienced entrepreneurs will have had successful careers managing venture capital investments, newer startup companies will have less experience. Because this is not a known quantity, entrepreneurs should always perform due diligence in order to make sure that they are making the best decisions for their own personal finances. Most angel investors do not require the entrepreneur to personally guarantee their investment as part of the standard arrangement for VC funding. However, this is not always the case and should be discussed with the vc during the due diligence process.
Private equity firms are another source of vc funding that are rarely disclosed to potential investors. These firms typically operate as Limited Partnership Associations and will occasionally solicit venture capital from limited partners without first obtaining an equity commitment from the partner(s). Limited partnerships will normally have much lower start up costs and an easier time raising money compared to startup companies due to their shorter duration of operation and lack of public disclosure requirements. The primary benefit of raising funds from these limited partnerships is that they will pay lower returns compared to the combined cost of the venture capital and personal equity contributions. However, the downside to this scenario is that the partner’s stake in the company may not be significantly higher than the overall value of the company. This is why venture capital firms will often solicit equity from private equity firms as well.