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What's the Deal with Venture Capital? (Definition, Process, and Trends)

July 31, 2019

The startup trend is showing no signs of slowing down.

However, finding a sufficient source of funding to fuel their startup remains a big challenge for small business owners.

In fact, 65% of startup owners admit to not being confident they had enough money to start their business. This makes education around funding options for small businesses that much more important to explore. Every small business owner should look at their options, what they offer, what they have to sacrifice, and the circumstances that call for each.

While some might ask for money from friends and family or learn the tricks on how to get a small business loan, others might turn to venture capital.

Already familiar with the basics and want to skip ahead? Feel free!

Venture capital basics

A popular form of business funding, venture capital is a source of money for both new and existing businesses.

This is a great funding option for businesses that don’t have much of a history and are unable to get funding elsewhere.

Venture capital can come from well off individuals, investment firms, or any other type of financial institution. While it typically takes the form of monetary funds, venture capitalists can also contribute their business experience, which can sometimes be equally as valuable to a first-time business owner.

Find the best Investment Firms for 2019 →

While venture capitalists get equity in return for their investment, which also means ownership and a say in the decision-making process, these investments pose a big risk. However, this is easily justifiable with the potential of getting a decent return and being a partial owner of a successful business.

History of venture capital

Before venture capital, funding for small businesses from investors was limited to private equity, which is when someone invests in a business that is not publicly traded and restructures it to make it more successful.

Venture capital developed as its own industry after World War II. It all started when Georges Dariot, the father of venture capital, started the American Research and Development Corporation (ARDC) in 1946 and raised $3.5 million to invest in technologies that were developed during the war.

The growth of technology did a lot of the heavy lifting in supporting the growing popularity of venture capital. New businesses and innovations were emerging at a rapid pace, and they all showed significant signs of growth and potential, making them enticing for venture capitalists.

On top of that, a change in the Small Business Investment Act provided a tax break for those who invested in small businesses. A couple of years later, the Revenue Act reduced capital gains tax by almost half, from 49.5% to 28%. Not long after that, the Employee Retirement Income Security Act (ERISA) allowed pension funds to invest 10% in the industry. This led to a large amount of capital being distributed from rich pension funds.

Eventually, the capital gains tax was reduced even further, the dot com industry created a lot of promising businesses, and venture capital continued to gain popularity.

growth of venture capital

Venture capital process

To better understand how venture capital works, let’s go through the typical process.

Idea generation and business plan

The aspiring business owner will first have to come up with a genius idea and nail the individual elements of a business plan. If it doesn’t sound promising or profitable to the venture capitalist, they won’t invest. If they think the business has the potential to return a solid profit, they will move on to the due diligence step.

Perform due diligence

Due diligence is the fact-checking process for potential investors. During this process, the investor will take a look at everything that could potentially help or hinder the business they are considering funding: financial statements, company capitalization, revenue, margin trends, competitors in the industry, management, and risks.

The investor makes a pledge

If the due diligence process shows the venture capitalist that the business is a worthy investment, they will make a pledge in exchange for a certain amount of equity. Sometimes the funds are given all at once, other times they are distributed in rounds. It all depends on the venture capitalist.

The grand exit

After an agreed-upon amount of time, the investor will exit the company. When exiting, they can get their return on investment in one of four ways: initial public offering, promoter buyback, mergers and acquisitions, or selling their stock to another investor.

Venture capital vs private equity

Venture capital and private equity both refer to people or firms investing in companies and then exiting at a certain point to get their investment back in one way or another. However, there are a few key differences between the two.

The main differences between venture capital and private equity arise in the status of the businesses being invested in, the portion of ownership, and the amount invested.

private equity and venture capital

Overall, private equity firms go all in and invest large amounts in one existing company in exchange for complete ownership. Venture capital firms, on the other hand, invest small amounts in new businesses in exchange for partial ownership.

Venture capital trends

Lucky for venture capital, there are a lot of undiscovered business ideas out there. And as more people keep uncovering them, venture capital maintains its popularity, but it also sees some changes according to these trends.

Larger funds are being created

As time goes on and venture capitalists learn more from past experience of themselves and others, they understand more about strategically placing their money to get the biggest return. In most cases, it is internet and technology companies. Because of this, venture capital funds have become concentrated in this industry.

Remember Yahoo? While its glory days may be over, one of its early investors, Masayoshi Son, is far from finished. This year, his telecommunication and internet company, Softbank, has a venture capital fund with a whopping $100 billion.

To put that in perspective, $64 million was raised in venture capital in 2016. Across all industries and businesses.

This enormous fund for SoftBank is seen as an industry disrupter.

But fewer investments are being made

While more money is being invested, fewer companies are getting their piece of the pie.

In 2018, the total value of venture capital deals was $84.3 billion, the highest it has ever been. However, less than 7,000 deals were made. There haven’t been that few venture capital deals since 2012.

Direct listing over IPO

There is more than one way for a business to earn capital when going public.

The typical method is with an initial public offering (IPO). With an IPO, a private company, with the help of an intermediary, creates new shares to be bought by investors. Another method is with direct listings, where businesses sell shares to the public without using an intermediary.

Spotify was one of the first big companies to go public with a direct listing over an IPO, and Slack and Airbnb weren’t far behind on the bandwagon.

Venture on

When starting a new business, there are a lot of options for finding the right source of funding. If letting go of some ownership of your business in return for funding and guidance sounds like a good trade-off, seeking money from a venture capitalist might be the best route for you to start, establish, and grow your business.

Learn more about capital, specifically the capital structure that keeps your business together. 

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