How Does Venture Funding Work?

Raising venture capital funding can seem daunting to both new and seasoned entrepreneurs due to marketing jargon, overly technical terminology, and ever-changing definitions. While venture capital remains a daunting option, it remains an increasingly popular and attractive option for businesses who have been rejected by more traditional lenders - as well as for entrepreneurs looking to scale quickly with a firm eye on an eventual, lucrative exit. What is venture capital funding? What are the different stages of investment? What does a venture capital firm offer besides investment? Read on below to find out…

What is venture capital funding and how does it work?

Venture capital funds are investment funds financed by wealthy individuals or companies who give their money to VC firms to manage their investment portfolios and invest in high-risk start-ups in exchange for equity. Investors are informed what funds and businesses their money is being invested into, as well as the potential risks and rewards of the investments. It's common for venture capital firms to target a certain amount of money or a particular sector when raising a fund. The fund will typically finance multiple companies - the range of probable investments is normally announced when the fund launches. Most start-ups who raise venture capital funding have been declined funding by traditional lenders, such as banks, because they're deemed to risky. In fact, of those that don't fail (which will be many), they are likely to provide investors with a substantial return over the long run. In spite of the fact that venture capital firms are aware not all investments will pay off, they hope that the ones that do will be so successful that they will not only compensate for any losses, but also exceed them. Unlike venture capital funding, venture capital funding is by no means a guarantee of success, and for many venture capital firms it is more like commercial fishing: if they cast a large enough net (invest in multiple businesses), they are bound to catch something. Many investors will have additional requirements as part of their investment contract. The individual may be interested in serving on the board of directors or participating in certain recruitment practices. The biggest benefit of working with investors is that, because of their industry knowledge and experience, they can offer you so much more than just cold hard cash.

The difference between investment stages

10 or 15 years ago, venture capital funding was almost exclusively reserved for a select few start-ups with massive growth potential or an abundance of connections, however recent years has seen a growth in finance available to companies of all sizes and sectors. You may have previously been enticed to bootstrap completely, but the likelihood is that you will need more than just family and friends to launch and scale your start-up. With numerous startups securing funding almost every day, coupled with the exponential growth of alternative forms of finance like crowdfunding, businesses can get overwhelmed and confused by the various types of venture funding currently available. What does each of the different funding series (pre-seed, seed, Series A, Series B, Series C, etc.) mean? Each letter corresponds to the stage of development of the startup that has received funding. However, it is important to remember that as the number of start-ups accessing venture capital funding changes, so does the definition of each round.

What is pre-seed funding and seed capital?

A start-up's pre-seed and seed funding stages serve a similar purpose - and take place when the company is very early in its journey, sometimes less than a year old. Funding for seed-stage businesses is commonly used to support the market research and R&D stages. This is often when a start-up is still at the prototype stage and may not even know their target market. In many cases, the seed stage is the first opportunity to hire people outside of the original founding members. At the pre-seed and seed funding stage, angel investors and early-stage venture capital firms are the main backers - a stage that is both the most daunting for entrepreneurs and the riskiest for investors, given the lack of track record of the start-up. Typically, a seed funding round contains fewer than 15 investors, who will gain convertible notes, equity, or a preferred stock option in exchange for their backing. On average, most pre-seed rounds describe a funding round of around $100,000-$250,000, with the relevant startup having a valuation in the $1-$2 million range – while seed funding will typically occur around the $1m - $2m mark (but sometimes more). Even if a business has unfinished aspects or is still in the development stage when looking for seed capital, they will need a minimum viable product to raise seed capital, but not pre-seed funding. For entrepreneurs seeking a lucrative exit or IPO, pre-seed and seed funding rounds are stepping stones. Start-ups can benefit from pre-seed and seed financing from being given more time to fine-tune their business model, more time to find experienced business partners, increased capital for future rounds, and the flexibility to pivot if drastic changes are required.

What is Series A funding?

Seed funding can certainly be raised based only on potential, but Series A funding is all about showing that your start-up has a proven track record and the ability to scale quickly and deliver a significant return on investment. For a start-up looking to raise Series A capital, it can be helpful to consider whether you have a market-proven product that will allow you to easily multiply your revenue within 18 months - because that is what investors are interested in. It is not uncommon for start-ups to skip seed funding and raise Series A funds directly. This normally happens when a venture capital firm approaches the startup. In such a case, however, the entrepreneur might be asked to give away a fair amount of equity - usually more than 20%. Instead of backing a rookie, investors are more likely to invest in a business at the Series A stage, which has not raised seed funding, if the entrepreneur has already been successful with a previous startup, or has significant experience and connections within their industry. An average Series A round of funding ranges from $2m to $15m - though it can be much higher if the business has 'unicorn potential' (a unicorn is a company valued over $1bn). As opposed to seed funding rounds, investors at the Series A stage will be more traditional venture capital firms, with angel investors having less influence. It is usually a few of the bigger firms that lead the investment, often strategically speaking. At the Series A stage, a start-up's valuation will be determined by its proof of concept, progress with seed capital, quality of the executive team, and the risk it faces. Start-ups that raise Series A have the ability to scale faster thanks to a larger financial reserve - as well as increased recognition within their industry.

What is Series B funding?

Series B is all about building - and at this stage, start-ups should have proven they have a perfect product-market fit and a scalable marketing model. Those looking to raise Series B capital will have fully launched their product/service and will be aiming to capture market share in their chosen sectors. They will also be competing with larger and more established companies. It's likely that businesses raising Series B will already have a significant turnover. However, it's at this point that they will start to turn a profit. Series B rounds typically range between $7m to $20m - and the process and investors involved will be quite similar to Series A. A Series B funding round may, however, include venture capital firms that specialize in later stage investments. Often considered to be the most difficult round to raise, while Series B start-ups are considered less-risky than those at seed or Series A stage, investors are no longer able to suspend disbelief and back the business based on potential. Seed is raised on vision, Series A on hope, and Series B is raised on pure facts and figures. It's a stage of slow growth for start-ups (Series C is where scale-ups start to grow rapidly), and Series B isn't the most popular stage for investors either, as they'd rather invest cheaper at Series A or at Series C with less risk. Most businesses that successfully raise Series B funding will invest in business development, sales, advertising, and tech - as well as begin looking at possible international expansion. Series B valuations are based on a start-up's performance in comparison to its sector, revenue forecasts, as well as assets such as intellectual property.

What is Series C funding?

With the Series C stage of funding, startups have already demonstrated to venture capital firms that they'll be a long-term success - with the value of original backers' shares now increasing considerably. From an investor's standpoint, Series C raises are therefore considered a very safe bet. At the Series C stage, businesses are more likely to look for a larger market share, develop new products, and start planning for a potential acquisition - either by a larger corporation or by acquiring a smaller competitor. In the final phase before an Initial Public Offering (IPO), valuation of a business at Series C is based on hard data, with this round more an exit strategy for venture capital firms. At this stage, hedge funds, investment banks, private equity firms, and major secondary market groups will all be investing in companies that can raise anything from tens of millions to hundreds of millions.

What is the role of a venture capitalist?

Even those with the most ill-informed views about what constitutes a sensible investment can now back start-ups to their heart's content due to “armchair investors” unstoppable rise. Businesses can now raise millions of dollars worth of investment with alternative sources of funding, such as crowdfunding, without giving up a dollar of equity. Why do businesses decide to part with larger chunks of equity and seek venture capital? Often, this is due to the role of venture capitalists - and what they can offer besides the initial injection of cash.

 What services can a venture capital firm offer besides investment?

  • Support services: Venture capital firms are increasingly offering marketing, legal, and recruitment services to start-ups and smaller businesses receiving investment.
  • Strategic introductions: Experienced entrepreneurs themselves, investors, or venture capital partners have a wealth of contacts that your business should be able to tap into. This type of introduction will be highly specific, strategic, and targeted. Potential introductions could include partnerships with larger corporations, new investors or clients, or even potential hires.
  • Experience in efficiency: Investors and businesspeople who are experienced can streamline communication channels and facilitate productive boardroom meetings. From the top down, an investor can help form strategy and direction for your business.
  • Wider market knowledge: While you are likely to have spent most of your time working on your own business, venture capitalists have been searching for opportunities. As a result, engaged investors can provide much needed insight into international markets, potential new clients, and even exit opportunities.
  • Best practice: Investors can significantly add value by promoting good governance in areas such as financial controls and reporting, business ethics, and contractual issues.

When sizing up potential investors, ask yourself if you'd want them on your board without their cash. If the answer is 'no,' you should probably put it aside, if it is 'yes,' you are likely to make a better decision.