A Definitive Guide to How Venture Capital Works

understanding venture capital

Venture Capital – An Introduction

The global venture capital market soared to $300.5 billion in 2020, the second-biggest year for venture capital funding in a decade.

In Canada, 2019 saw $6.2 billion in investments in homegrown startups.

Although modern venture capital has been around for less than a hundred years, today, it is one of the most popular financing methods.

But what is venture capital, and how does it work?

If you are an entrepreneur or startup founder, this might be the question on your mind.

This guide unpacks venture capital, covering essential areas like what it is, how it works, and how to get funded by a venture capitalist.

Let’s dive in.

Table of Contents

What is Venture Capital?

Venture capital is a type of equity investment that takes educated risks by investing in high-growth, high-potential ventures. Venture capitalists (VCs) typically invest in risky startups hoping they make a significant return within two to ten years to cover their initial investment.

In exchange for capital, venture capitalists take a stake in the company, tying their return on investment or ROI to the company’s success. Since venture capital investments are high-risk and the money can be lost, venture capitalists spread their risk through multiple investments in different startups and competing industries.

How Does Venture Capital Work?
At a high level, venture capital works this way:

  1. An investor commits money to an investment fund managed by a venture capital firm.
  2. The firm scouts for investment opportunities and makes investments in a handful of startups that become portfolio companies.
  3. Portfolio companies are groomed for growth, and each year, investors are paid a dividend from the collective profits earned.
  4. If the venture capital firm exits an investment through an IPO or sale, the investors share the returns.

What Purpose Does Venture Capital Serve?
Most investors would not risk their money on a company with a limited history, new business model, or novel product. Venture capitalists assume this risk and invest in such high-risk ventures. Because of venture capital, companies like Google, PayPal, Stripe, and Airbnb survived to become billion-dollar companies.

Venture Capital vs. Private Equity vs. Debt vs. Angel Investors

Venture capital exists alongside other investment types like private equity and angel investing but differs slightly from them.

Here’s a quick comparison between venture capital and other types of equity and non-equity investments:

Venture Capital vs. Private Equity
Private equity funds invest in medium to low-risk ventures like established businesses, rapidly growing companies, or mergers and acquisitions. Unlike venture capital that tries to spot the next big company early, private equity plays it safe and only gets in when its growth potential is proven.

Venture Capital vs. Debt
Debt instruments are not tied to equity or the success of a company. Instead, they rely on cash flow and other financial fundamentals that demonstrate a company’s ability to make payments. Startups usually do not qualify for debt because most have little to no cash flow or financial history.

Venture Capital vs. Angel Investors
Angel investors invest small amounts of capital in a startup when it is nothing more than an idea. While venture capitalists require some proof that an idea will work like early customers, early employees, or some market research, angel investors bet their money on nothing more than an idea.

Where Do VCs Get Money?

Venture capitalists invest billions of dollars every year in risky startups. Where does this money come from?

Venture capital firms manage funds that draw money from various sources. Each firm will have one or more funds under management, which they have raised and “closed” before looking for and investing in startups.

These are the primary sources of money for venture capital funds and how much they typically invest:

Wealthy Individuals – $50k to $1m
Wealthy individuals, also known as high-net-worth individuals, invest in venture capital funds as part of their investment strategy. Such individuals usually are professionals with a net worth of over $1 million who invest in industries that they have worked in and know well.

Family Offices – $1m to $10m
Family offices manage multi-generational family wealth through a collective investment strategy. Although they employ professional investors, some choose to invest in venture capital funds as part of a high-risk/high-reward investment strategy.

Foundations – $1m to $100m
Foundations like the Rockefeller Foundation and the Bill and Melinda Gates Foundation invest in funds aligned with their goals. For instance, the Rockefeller Foundation’s Zero Gap Fund mobilizes venture capital resources that help accelerate the world’s achievement of the Sustainable Development Goals.

Endowments – $1m to $100m
University endowments invest in venture capital funds, especially those that fund startups emerging from within the university. For example, Harvard University, Yale University, and Stanford University, with endowments of $40.58, $31.20, and $28.95 billion, respectively, invest some of their substantial resources in venture capital funds.

Government Grants – $10m to $1b+
Governments invest in domestic venture capital funds to nurture the local startup ecosystem. For example, the Canadian government made available $450 million through the Venture Capital Catalyst Initiative (VCCI) with plans to inject a total of $1.7 billion into the Canadian venture capital market.

Fund of funds – $10m to $1b+
Fund of funds (FOF) pool money from investors and invest in other funds rather than invest directly in startups. Most FOFs have massive amounts under management and so can make significant investments in venture capital funds.

Institutional Investors – $10m to $1b+
Institutional investors include pension funds, banks, and sovereign wealth funds. For example, the world’s richest sovereign wealth fund, the Norway Oil Fund, with over 1.2 trillion dollars under management, has over 9,000 investments in over 70 countries made directly or through venture capital funds.

The Venture Capital Financing Cycle

Now that we have covered what venture capital is and where venture capitalists get money let’s zoom in a little on how VCs fund companies.

Venture capitalists invest in companies at various stages of growth, usually investing more considerable sums in portfolio companies or those of other funds as they grow or scale.

These are the five levels of investments VCs make:

Seed stage
Seed stage investments help a startup figure out its product, market, and customer base. A VC firm will make a small initial investment of between $250,000 and $2M at this stage to keep tabs on the startup and have a front-row seat increase it takes off. According to CB Insights, seed-stage investments are the riskiest and have a 66.2% risk of loss.

Series A
Startups raising a Series A round usually have product-market fit and a growing user/customer base. Since they have demonstrated that they can generate profits in the long run, VCs invest larger sums of between $2M and $15M. At this point, the startup might invite other VCs to participate in the fundraising round.

Series B
Series B funding is intended to help a startup scale rapidly. Startups raising this round will have established themselves in a significant market and are already experiencing the beginnings of rapid growth. Venture capitalists at this round will typically put up between $20M and $100M either individually or together with other funds.

Series C
Startups seeking Series C funding will be gearing up for an exit event like an IPO, sale, or M&A (merger and acquisition). VCs investing at this stage do so in readiness for the exit event or to capitalize on the rapid growth the company is currently undergoing. Since investments at this stage only have a 20% risk of loss, VCs commit amounts over $250M.

Late-stage investments come when a startup is getting ready to debut on the stock market. The funds are used to make the company more attractive by broadening its reach, purchasing rivals, or driving down prices. VCs at this stage can commit more than $1B, knowing the risk of loss is low, and an exit is imminent.

Venture Capital Pros and Cons

Venture capital has many strengths, but it also has some weaknesses too.

As an entrepreneur interested in venture capital funding, it is essential to look at both sides of the coin and weigh the pros and cons of receiving venture capital investments.

Venture Capital Pros

  • Growth is easier and faster: Extra resources VCs provide make it easier to hire more people, spend more on sales and marketing, and generally grow the company faster.
  • Venture capital is not debt: VCs take the risk of investing in your company with no collateral or obligation to repay. If the company fails, you do not owe the VCs the money they invested.
  • Access to a seasoned technical team: Once funding is secured, most VC firms provide access to a seasoned team of marketers, developers, accountants, and other technical skills that would be too expensive for a startup to afford.
  • Wide networks and connections: VCs have extensive industry networks and relationships, making it possible for a startup to score a major client, partner, or supplier despite the lack of a track record.
  • Board-level expertise and guidance: Startup founders may have lots of technical knowledge but lack strategic know-how. Having seasoned VCs sitting on your board offers extensive advice and experience to steer the company to success.
  • Capital to pivot: If the current business model or product is not working, some VCs will finance a pivot, especially if they see potential in the founding team. Startups that lack such resources are forced to shut down when faced with similar circumstances.
  • Help exiting: Since VCs want to cash out of the business as quickly as possible, they can help steer the company to a fast exit, helping the founder retire early.

Venture Capital Cons

  • Limited access to decision-makers: Most startup founders need an introduction to a VC from a person the VC trusts. If an entrepreneur lacks this “foot in the door,” it can be challenging to reach decision-makers.
  • Ownership dilution: VCs provide funding in exchange for equity, which can significantly dilute the founding owner’s equity. In some cases, the owner can lose control of the company entirely or the ability to make impactful decisions.
  • Early investment redemption: A VC might decide to cash out of the business before it matures through profit taking or selling it. Such early cash-outs can thwart any long-term plans the founder had for the company.
  • Long and challenging process: Getting venture funding is not for the faint-hearted as it often comes with multiple rejections, long wait periods, and in some cases, undervalued offers that a founder will find challenging to accept.
  • Competitive market: Even after securing funding, startups must still compete for subsequent funding rounds. If a unicorn emerges, it might get all the attention and budget at the expense of other startups in the portfolio.
  • False growth: Venture capital can sometimes create the illusion of growth because of all the money financing the artificial growth. When funding stops, there’s usually nothing to stop the company’s free fall into insolvency.

Venture Capital Firm Structure

Venture capital firms have a diverse team setup that makes it easier to pick winning bets. As an entrepreneur, understanding the inner workings of a VC firm ensures you know who the gatekeepers are and who the decision-makers are.

These are the primary roles in a VC firm:

Limited Partner (LP)
A Limited Partner is an investor in a venture capital fund. They are called limited partners because their involvement in the fund is limited to the money they have invested in the fund. Limited partners can be individuals, companies, governments, or any other entity.

General Partner (GP)
General Partners oversee the fund and have the final say when it comes to investing decisions. They are seasoned professionals with a background in finance and have extensive experience in picking companies to invest in.

Managing Partner (MP)
Sometimes a fund will have a Managing Partner who manages the day-to-day running of the fund. While a Managing Partner may also be a General Partner in terms of their rank, the role is limited to managing the operational aspect of the fund in larger VC firms.

Technical Partners
Larger firms have technical partners like Chief Financial Partner, Chief Marketing Partner, Chief Technology Partner, and Chief Human Resource Partner, who oversee portfolio companies in an advisory capacity. For example, all Chief Financial Officers in respective portfolio companies report to the Chief Financial Partner.

Principals and Associates
Principals and associates are considered the fund gatekeepers since they must sign off on an investment opportunity before it lands on a GP’s desk. In most cases, they are professional investment analysts with extensive experience who understand the inner workings of their industry. GPs rely on them to filter out 90% of investment opportunities.

Investment Analysts
Venture capital investment analysts are junior officials whose primary responsibility is to collect data on emerging trends, startups, industries, and anything else to help the firm find the next unicorn. They attend conferences, pitch events, and university showcase events and compile reports and possible investments that they then forward to principals and associates.

Entrepreneur-in-Residence (EIR)
An entrepreneur-in-residence is an experienced entrepreneur with a history of founding successful startups that went on to a profitable exit. In most VC firms, the EIR is an alum of the firm and, in some cases, has also invested in the firm’s fund as a Limited Partner.

How Do Venture Capitalists Pick an Investment?

As you can see from the structure, there are multiple decision-makers.

As an industry average, this structure ensures that for every 1000 startups that pass the junior analyst, associate, principal, and general partner’s desks, only two to three will receive funding.

That’s a 0.3% chance of success!

It might sound picky but keep in mind one in ten startups fail within two years, so of the ones that make it, only one in ten will see substantial success, and this one must pay for the nine failed investments.

What do these decision-makers look for in a startup?

It turns out they all look for four main things: the right industry, market size, founding team, and product.

If a startup is in a high-growth or emerging industry like robotics, artificial intelligence, or life sciences, it might have a higher chance of getting funding. Although different VCs focus on different industries, most invest in high-growth, high-potential industries.

Market Size
A startup’s maximum addressable and serviceable market must be large enough to guarantee strong growth well into the future. The maximum addressable market represents all potential customers within the target market. In contrast, the maximum serviceable market is the portion of the addressable market that the startup can profitably reach with limited resources.

Founding Team
Most venture capitalists are heavily biased towards founding teams that either come from a previous successful startup or have extensive industry experience. Although VCs have been known to fund solo acts, this is the exception to the rule as they always look for a founding team in prospective startups.

The product is the final piece of the puzzle. Here, VCs want to see a compelling minimum viable product (MVP) and a road map of how the product will evolve. It’s important to note that most VCs will not fund a service-based startup unless it has a unique competitive advantage that competitors cannot easily copy.

How Do Venture Capitalists Make Money?

Now to the million, or perhaps, billion-dollar question: how in the world do VCs make money for themselves and investors?

VCs make money in several ways, which can be looked at as short, mid, and long-term earnings.

Let’s break it down:

Short-term Earnings: Management fees 
General partners are paid management fees of 2% to 2.5% of the fund value. For example, if a fund has $100M under management, the GPs are paid $2M per year, regardless of how the fund performs. GPs are paid this fee as compensation for managing the fund.

Mid-term Earnings: Profit Share
Any profits portfolio companies make are shared between the LPs and GPs using the carried interest principle. For example, if a $100M fund returns $20M annually as profit, the entire profits will be paid to the Limited Partners for five years for a total of $100M. After that, they split the profits 80/20 between the LPs and GPs, respectively.

Long-term Earnings: Exit Event (IPO/Sale/Merger)
In some cases, a fund may take a company public through an initial public offering (IPO) or sell it to another company. In such cases, the VC “exits” and the returns split according to the carried interest principle explained above. Most VCs favor IPO exits because they unlock significant returns for everyone: investors (LPs), fund managers (GPs), and startup founders.

How to Get Funded by a Venture Capitalist

So far, we have looked at venture capital from the VC’s perspective.

This next section looks at venture capital from an entrepreneur’s perspective, starting with how to get funded by a VC.

You know by now that a small percentage of companies get venture capital funding, but that should not deter you from trying your luck!

Here’s what you can do to increase your chances of getting venture capital funding:

Evaluate Your Company
Not all startups qualify or even need venture capital. If your business is up and running, you may be eligible for a loan. Similarly, if you are in the services industry, your business may not qualify for venture capital.

Take some time to research the companies that have received venture funding in your city and try and compare your startup to what they offer. If there are many similarities (high-growth potential, large market, unique product, and strong founding team), you have a higher chance of success.

Incorporate Your Business
You must register your business to establish ownership before approaching a VC firm. We recommend incorporating a limited company that offers more flexibility and protections when negotiating with a VC.

Ontario Business Central makes it easy to incorporate your company online quickly and affordably.   We offer services to assist you to incorporate in Ontario, Alberta, B.C. Manitoba, Saskatchewan, or Canada/Federal.  The selection of the jurisdiction should be based on where the corporation will reside or operate.  Each incorporator has access to opt to federally incorporate instead of completing a Provincial incorporation.  The federal incorporation provides better name protection and requires submission into the Province of operation for the business as a secondary requirement.  Here is a listing of the pro’s and con’s to federal incorporation.

Create A Pitch Deck and Elevator Pitch
A pitch deck is a set of slides briefly explaining your startup idea. Ensure it is no more than five to ten slides, as most VCs will not go through a lengthier presentation.

Also, summarize your startup idea into an elevator pitch, a short statement that captures your value proposition and generates interest to find out more.

Prepare for Due Diligence
VCs always perform due diligence at the final funding stages. Prepare for this by compiling all necessary documents like financial accounts, supplier and employee contracts, and IP registration documents. The last thing you want is to start scrambling around for these documents when you are called in for a meeting.

Be Patient and Persistent
Venture capital deals can take from six to twelve months to close. If you have received a positive response from a VC, give them time but check in every month to find out the progress. If you have not received a favorable response, refine your pitch deck, and resend it, even as you keep approaching other VCs.

What to Look for in a VC Firm

As you look around for a venture capital firm to fund you, you should know that not all will be a good fit.

Some might not fund startups in your industry, while others might offer you a small sum for a significant stake in your company.

Use the following pointers to pick the best VC for your company:

Industry Fit
VCs specializing in specific industries usually have the expertise and connections to help your company grow in that industry. For example, a clean energy VC fund will be more likely to fund your startup if it is in that industry, which can help you avoid competing with startups in other sectors.

Top VCs have extensive network connections in their industry. A lack of connections means they might not be able to help you get the right partners or suppliers. An excellent way to find out whether a VC has links is to talk to startups that they previously funded and ask how much they helped secure crucial contracts.

Management Team Experience
Although most GPs will have a background in finance, find out what other industry experience they have, including the companies they worked for previously and if they have been involved in a startup before. A great place to find this information is on LinkedIn.

Track Record
The firm’s track record is the ultimate source of truth. Find out what startups they have funded in the past and how they did. Did they exit, shut down, or were sold? While most VCs will not list failed portfolio companies on their website, you can find this information on websites like CrunchBase.

Fund Size
The fund size will tell you whether the fund can support you through growth and whether you have a shot at getting funded. Smaller VC funds are more open to listening to startups, while larger funds will be difficult to access because they usually have many applications to review.

Professional Integrity
VCs with integrity will work hard to ensure everyone wins. Avoid VCs who rush to exit or who require that you relinquish a significant portion of equity at the seed fund stage. The best VCs have glowing recommendations from previously funded startups, which you can get by seeking out their founders.

VCs who advocate for the startup founders to the board, partners, and vendors make it easy for the startup founders to grow the company. Even when founders make mistakes, the best VCs will stand by them and help them bounce back from the error and emerge stronger and wiser.

What to Expect After Receiving Venture Capital Funding

If you make it through the review process and are ready to receive the wire transfer, there are several essential things you should be prepared for.

They include:

Term Sheet
Once the VC firm agrees to fund your startup, they will provide you with a term sheet. A term sheet is a short non-binding document that outlines the dollar value of funds raised, the company valuation, investor rights, and share classes. As a startup founder, it represents the outline of the deal you are receiving. In most cases, this is the best place to negotiate different terms before binding contracts are signed.

Management Oversight 
By receiving VC funding, you accept that someone else will influence the decisions you make in your company. For example, if you plan to open a new office, the board must discuss this proposal before deciding. At best, the startup founder will have to make a strong case for the decisions they want to make.

Ownership Dilution
All VC deals lead to ownership dilution for the founder, so the real question is how much dilution you are comfortable with. Some VCs will take as little as 20% or as much as 45%, depending on the initial investment size. In subsequent rounds, they might require the founder to relinquish more shares or dilute their ownership further by issuing additional shares.

Potential Exit
Once you receive funding, the road to an exit begins. It might be five to ten years in the future, but it’s a reality you should prepare for. If you wish to retain control of the company past that date, you might want to plan how you will buy back your company with the profits you earn. You should also be ready for an early exit through a sale or merger, which might push you out of the company, especially if the new owners want someone else at the helm.

In Summary

Venture capital plays a vital role in helping the startup economy thrive. Without their support, global companies like Microsoft, Apple, LinkedIn, Facebook, and Google would not exist today.

As a founder and entrepreneur, this guide on how venture capital works should prepare you for your fundraising journey, so you know what to expect and how to approach the venture capital firms you pick.

Although getting venture capital funding is not guaranteed, going through the fundraising process can help you fine-tune your idea and develop a thick skin, two essential things that can help you succeed as a startup founder.

We have provided an overview of Venture Capital options in Canada, it is always recommended to speak with a legal representative, accountant, financial advisor, or other financial experts to see what the best options are for you and your business.

Should you have any questions, please feel free to reach out to our staff for additional information and assistance.

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Ontario Business Central Inc. is not a law firm and cannot provide a legal opinion or advice. This information is to assist you in understanding the requirements of registration within the chosen jurisdiction. It is always recommended, when you have legal or accounting questions that you speak to a qualified professional.