What do venture capitalists want in an investment? If you have to ask, then you (and your business) are probably not a good candidate. And—just in case you don’t recognize it—that’s a reference to an old joke: When someone asks a Ferrari salesman how much it costs, the salesman answers, “If you have to ask, you can’t afford it.”
I introduce this topic with that reworked joke because so many people say “venture capital” when they really mean “angel investors” or “outside investors.” Venture capital is very specialized. There are about 500 venture capital firms in the U.S.
Consider this bar chart from the National Venture Capital Association. Notice that venture capital does roughly 4,000 deals per year, and the average is about $20-$30 million per deal. That includes initial investment and follow up. For more on this, read this article on the difference between angel investors and venture capital.
Angel investment on steroids
Venture capital wants all the qualities angel investors want, but bigger and better. The venture capitalists (also called VCs) focus on high returns for high risk. Just like most angel investors, they’re not looking just for a healthy company, or just dividends; they are buying percentages of ownership of companies with the intention of selling those percentages for 10, 20, 50 or more times what they originally invested. They make the money when they exit, which is what happens when they sell their share of ownership for real money.
The collection of investments a VC makes is called a portfolio. The companies they’ve invested in are in their portfolio. A successful portfolio grows at least 10x every two or three years, and that’s growth in real money, after exits.
And it’s a hit business, so they can’t expect returns over the whole collection of companies. The winners have to pay for the losers. The National Venture Capital Association says about 40 percent of VC-backed companies fail, another 40 percent have moderate returns, and only about 20 percent are really successful.
VCs invest in companies that have real possibilities for huge growth. They have to have very strong management teams. They have to be able to scale up—meaning get to high volume of sales—rapidly. They have to have something different, like a “secret sauce” or technology, that will defend them against getting eaten up by strong competition.
Consider the deal size in the chart above, and think about what it takes to invest $20 million per deal. The venture capitalists (also called VCs) raise funds of hundreds of millions and even billions of dollars about every three years. It comes from larger organizations like insurance companies and university endowment funds, sometimes enterprises, and even some very wealthy individuals. Taking that money carries with it an obligation to invest that money in promising startups and emerging businesses.
Venture capital is more likely looking at follow-up rounds, of more money, after the early money that invests in the beginning. Investors often talk about the “seed round” as the first few hundred thousand dollars, then “series A” comes for a few million after the seed funding has generated traction and credibility, followed by series B, and series C, each round getting bigger (meaning more money).
With investment amounts that high, the stakes are correspondingly high. So venture capital, these days, is usually involved in the later rounds, not in the seed rounds.
If you’re still not sure which funding source is right for you, or even what options are available when it comes time to secure funding, take a look at our infographic: 4 Ways to Secure Funding for your Startup
Do you have questions about venture capital? Share them with us in the comments below.
This article is part of our Business Funding Guide: fund your business today, with Bplans.
Tim Berry is the founder and chairman of Palo Alto Software and Bplans.com. Follow him on Twitter @Timberry.
