Venture Capital Basics for New Businesses
April 13, 2009 by Lela Davidson
Filed under Finance
You have to have money to make money, the saying goes. But how do you get that seed money for your greatest-of-its-kind unique business idea? Especially when you need a lot of it? Venture Capital!
Options for Financing a New Business
When you start a new business, you’re going to need cash for all kinds of things – physical space, furniture, equipment, office supplies, prototypes, and sooner than later, payroll. New business owners have a few options for raising capital:
- Personal Savings: Empty your own bank account or tap the equity in your home.
- Loans: Borrowing from banks or family members can get you started.
- Bootstrapping: If the business is simple enough (especially if it’s service related) you can bootstrap it. Get it going with a tiny initial investment and then reinvest profits from the business itself to grow.
- Venture Capital: Especially if you need a large amount of start-up cash and you aren’t wealthy, venture capital can help a business grow quickly.
Venture Capitalists invest in all kinds of businesses, usually by gathering money from wealthy individuals, companies, and pension funds, into an investment fund which will pump money into new businesses according to their investment profile. They target the new companies with certain risks and rewards in mind.
A Typical VC Model
Venture Capital (VC) funds typically liquidate in 3 to 7 years. They expect companies to either go public by selling shares on a stock exchange or to purchased by another company in that time frame. Either way – whether cash is coming in from another company or from stockholders, the VC firm cashes out. If all goes well, there is more money in the fund than when they started and this is distributed back to the orginal investors.
New business is risky business, but VCs make their money when the companies they invest in go public. When this happens, millions of dollars can flow into the company. This makes up for the inevitable failures that are part of investing in new ideas or new ways of doing business. VC investors are looking for a return as high as 20% per year.
When Your Company Takes VC Funds
When your company is ready to start up or grow, you look for venture capital firms to invest in the company. You present your business plan to the VCs, and if they like it you get their money. This initial investment is called a seed round. New companies may receive VC three or four times before going public or getting acquired.
In return for their investment, the VCs take stock in the company. This usually comes with some voting or control rights such as a seat on the board of directors, or agreements to seek approval for certain transactions. If you’re very lucky, the VC provides not only cash, but also valuable business contacts or experience in your company’s industry.
Negotiating the VC Transaction
Henry Ford may have only wanted workers’ hands, and start-ups may just want VCs’ money. But that’s not the way it works. Just as Ford had to take the whole employee in order to get those productive hands, companies that take VC must accept the guidance and control of the VC partners. But how much is enough?
In order to decide just how much stock the VC firm receives, they work together with the founders to value the company. This is called the the pre-money valuation of the company. Once all parties agree on how much the company is worth, the VC firm invests the money. Now that the company has cash, its value is called the post-money valuation. The amount of company stock the VC firm receives is based on the percentage increase from the pre-money to the post-money valuations. This is often between 10% to 50%.
What’s Up With VCs and Internet Start-Ups?
While many types of businesses can be good candidates for VC, we hear a lot about this type of investing in the ‘dot com’ world. Remember what VC is good for – raising large amounts of money for fast growth. Many internet businesses need larges amounts of cash for advertising, equipment, and employees. And they don’t have time to bootstrap. Compounding the need for cash quickly is the rate of change online.
