Venture Capital: Definition, Process, and Current Trends

Entrepreneurs who need money for their ideas can seek out venture capital (VC) funds. VC firms work with private investors to develop balanced portfolios by funding startups. These firms strive to make strategic choices in where they invest. Some VC funds are allocated for specific industries to support growth in that area.

Venture capital benefits both the financial and startup sectors. Entrepreneurs get the money they need to grow their businesses, while at the same time, individuals have investment opportunities beyond stocks and bonds. Venture capital is a higher-risk investment, but it has significant potential for high returns. Learn more about this funding option.

How Does Venture Capital Work?

Venture capital involves more than just giving money to entrepreneurs with good ideas. Startup founders must present in-depth pitches to VC firms to win their support. Harvard Business School details the four key elements of VC funding:

• Intense scrutiny and frequent rejection of business plans;
• Providing oversight and involvement instead of just capital;
• Multi-stage financing of investments;
• Return of the investment, plus profits, to the original funders.

Wealthy individuals trust VC firms to invest their money successfully. To do this, VC firms rigorously vet potential. They stay involved in the success of the company, often by taking a seat on the board of directors. Eventually, the startup may become profitable enough to pay back the VC firm, plus interest.

Types of Venture Capital Funding

The type of venture capital you seek will depend on where you are in the startup development process. Here are the four types of venture capital you can apply for:

• Pre-seed: The SEC refers to this as the “friends and family” stage because those are the most common investors. The company is just an idea and lacks viable products or processes at this point.
• Seed: This stage is intended to get ideas off the ground. Founders develop their businesses and show they are viable. Some government programs, including the state of New York, have seed funding match programs to support entrepreneurs.
• Series A: During this time, the company is established but may need some adjustments to its product-market fit or production strategies to make it more sustainable.
• Series B: At this stage, the company is healthy and ready to grow. Series B funding is used to bring the business from a startup to a leader in the industry.

Early-stage companies are often riskier investments because they aren’t proven. It is easier to scale an existing business than to believe that an idea has the potential to become a successful company.

How Do I Get Venture Capital?

There are multiple steps to take if you are interested in seeking venture capital funding. Here is how you can win over investors with your innovative idea.

Sourcing and Screening Deals

VC firms only meet with a select few applicants. The first step is to pass the screening process, which occurs when the VC firm evaluates your business for industry fit, size, and business viability. Founders often submit questionnaires that allow VC firms to consider their business before moving forward.

Due Diligence

Due diligence refers to the in-depth research of a VC firm into potential startups to consider their viability. Companies that make it through the screening process need to pass the due diligence hurdle next. A few criteria that VC firms consider include the viability of the idea, the background of the founder, and the proposed use of funds. The more gaps in this information, the riskier the investment.

Due diligence mitigates risks because it allows companies to learn everything about potential startups before deciding to invest in them.

Structuring and Negotiating the Deal

If a startup makes it past the due diligence process, the founder might be invited to meet with the VC firm to negotiate a deal. During this time, the entrepreneur will present a pitch deck for how much money they would like and how they intend to use it. The VC firm will review the proposal and might counter with its own offer. Both parties will negotiate the investment amount, interest rate, repayment terms, and involvement.

Once the founder and VC firm are aligned, they can sign the term sheets, which formally outline this agreement.

Startup founders often prepare to negotiate before these meetings. They learn to develop a professional poker face and have a floor for funding that they will not go below. This way they don’t leave the room with less funding than they need.

Post-Investment Involvement

Once the funding is approved, the relationship between the founder and the VC firm can begin. Venture capitalists often stay involved in the operations of the startup and have at least one representative on the board of directors. The VC firm will provide mentorship and connections for the startup founder, increasing their chances of success.

This strong relationship isn’t just a perk of working with VC firms. Venture capitalists want to see a return on their investment and will guide founders to ensure they get their money back.

Trends in Venture Capital

Venture capital has been a tool to invest in potential businesses since the 19th century, but the concept continues to evolve as the startup sphere changes. VC firms continue to shift who and where they invest their funds. Here are a few trends that are guiding venture capital investment today.

Emerging Sectors and Technologies

VC funding shifts with startup trends and innovative technology. One of the biggest industries receiving VC funding right now is the field of artificial intelligence. In the past five years, American VC firms have invested $290 billion in startups related to AI. These include innovative companies in the automotive, software, and healthcare industries.

These areas are appealing to investors because everyone wants to get ahead of trends. VC firms are always looking for the next Google or Facebook to invest in before they become household names.

Geographic Shifts in Venture Capital

It’s easy to find VC firms in tech hubs like San Francisco and London; however, some investors are seeking “frontier markets” that are less explored and saturated. Countries like Kenya and Nigeria have large cities and young populations, which means there is a high potential for good ideas. However, these markets are also riskier because they are still evolving.

VC firms chase these frontier markets for the same reason they seek new industries. They want to find the next great entrepreneurs before anyone else does.

Impact of Economic and Market Conditions

Economic trends, market conditions, and global events can all affect the types of startups that VC firms are interested in. For example, during the COVID-19 pandemic, the number of startups supporting remote work surged. Today, investors and industry leaders are questioning the long-term viability of these companies.

The business sector often responds to economic trends. When markets are conservative and investors are saving money, VC firms are less likely to hand out funds. When investors are optimistic, the money flows more freely. Entrepreneurs can keep up with these trends to evaluate how their pitches might be received by venture capitalists.