Updated: September 30, 2021
Growing a business requires proper financing. If your start-up has considerable growth potential but needs financial assistance to move forward, it may be time to look into venture capital (VC) funding.
WHAT IS VC FUNDING?
Venture capital firms invest in start-ups and other early-stage companies with high growth potential in exchange for equity in the business. VC funds, which pool investments from institutional and private investors, are controlled by a small group of individuals who seek opportunities with significant payoff potential.
WHEN TO SEEK VC FUNDING
Securing VC funding is an arduous, time-consuming task that can take company founders time away from other important matters. Therefore, it is best not to seek out VC funding until you are in a position to be successful. Most VC firms will want to see that you have a strong management team in place, a viable product or service and a strong or growing customer base before investing in your company. Some VC firms specialize in later-stage funding, helping established companies take their business to the next level.
HOW TO OBTAIN VENTURE CAPITAL FINANCING
Assemble a solid pitch deck (a presentation that provides an overview of your business model, market opportunity, management team, financials and the amount of funding you need) and seek VC firms whose interests align with your company. VC firms typically focus on specific industry sectors (like tech, medicine, etc.), company stages and/or geographic regions.
VENTURE CAPITAL TERM SHEET EXPLAINED
When VC firms are serious about investing, they will present you with a term sheet. Though not binding, this will provide a blueprint of what to expect from your relationship with the firm. The term sheet will lay out the details of the firm’s financial investment and what the investors will seek in return from your company. The corporate governance section will outline how operational power will be distributed among the founders and investors. The term sheet will also address how the investors’ interests will be impacted if the company is liquidated, dissolved or sold.
HOW VALUATION OF YOUR COMPANY WORKS
The VC firm’s investment will be predicated on your company’s valuation. The valuation is an estimate of the company’s current worth and is based on many factors, including intangibles. Ultimately, the valuation will be negotiable and agreed upon by both parties. From an entrepreneur’s perspective, the higher the valuation the better.
- Discounted Cash Flow: This method discounts expected future cash flows to arrive at a present value.
- Risk Adjusted MPV: This process is similar to Discounted Cash Flow, except future cash flows are risk-adjusted based on the probability that they will actually occur.
- Venture Capital: With this method, investors calculate the present value of the business based on what they expect their return to be when they exit after a certain amount of time.
- Market Comparables: Using key ratios, this method estimates the valuation based on the market capitalization (or the market value of a publicly traded company’s shares) of comparable companies.
- Comparable Transaction: With this method, the value of the business is estimated based on comparable investments or mergers and acquisitions.
- Decision Tree Analysis: This method forecasts future outcomes by assigning certain probabilities to particular decisions that could be made.
TYPES OF VENTURE CAPITAL INVESTMENTS
The type of VC investment varies based on the stage of your business, and VC firms may specialize in one or more types of funding.
- Seed Capital: Entrepreneurs with an exceptional idea may be able to get seed funding to begin developing a business or product. However, VC firms rarely fund at this stage.
- Start-up Capital: This type of financing applies to companies with a sample product available and at least one principal working full-time. Funds may cover recruitment of additional management personnel, further development of the product, and introduction to the marketplace. Few VC firms are willing to finance at this stage.
- Early-Stage Capital: Many VC firms like to get in at this stage, in which companies have a management team in place, a product that is out the door, and sales that are increasing.
- Expansion Capital: This type of investment is meant for well-established companies looking to take their business to the next level. Many VC firms specialize in this stage of investing.
- Late-Stage Capital: This category applies to expanding companies that have already achieved impressive sales and that have multiple layers of management in place.
- Bridge Financing: Some VCs specialize in providing short-term funding and other assistance to businesses going through mergers and acquisitions, initial public offerings and recapitalizations.
BUILD A STRONG TEAM AROUND YOU
The experience and past success of the management team is a crucial factor not only in attracting VC funding but in the calculation of your business’ valuation. The leadership team should include individuals with impressive resumes, start-up experience and diverse skill sets that have a shared strategic vision for the future success of the business.
DUE DILIGENCE PROCESS
VC firms will do due diligence to further evaluate the potential risks and rewards associated with investing in your business. The due diligence time frame can range from a week to several months, in which the VC firm will take a deep dive to evaluate your team, market, product, traction, financials and legal issues, among other factors. VC firms may consider such questions as whether the founder is a good fit for the market or whether the product is differentiated enough from the competition. Prepare in advance for due diligence by assembling the documents that VC firms typically request, including financial statements, financial projections, revenue breakdowns, organization charts, active contracts, intellectual property registrations, business plan, market and competitive analyses, and a breakdown of how you plan to use the funds, among other documents.
VC deals are complex, and consulting with an experienced VC attorney is crucial to protecting your interests. Contact the experienced corporate law attorneys at Romano Law today.
Photo by Andrew Neel on Unsplash
