How does venture capital (VC) have the power to increase a start-up’s odds of success? Does this type of fundraising bring other benefits to a company? In what ways can financing support early-stage and later-stage businesses?
Many entrepreneurs choose to approach venture capital firms to help get their start-up companies off the ground, as well as to support funding rounds later in the life cycle. As of May 2022, global venture capital invested $3.1 billion in seed-stage companies – companies seeking financing for their very first steps. In fact, while VC investment in other funding stages dropped, seed funding increased 11% from the average $2.8 billion invested monthly at seed in 2021.
However, VC financing isn’t solely concerned with seed funding: its reach extends far further.
Generally, as a start-up matures, it advances through various rounds of funding. Beginning with a seed round, it moves onto Series A, Series B and then Series C funding rounds. Each round is defined by the company’s valuation – grounded in factors such as market size, risk, track record and assets – level of maturity, and growth prospects. Together, these aspects of the investment proposition impact the types of investors who might provide financial backing.
Angel investors are one of the most common types of investor at this initial stage. Most businesses raise between $10,000 and $2 million in the first round and use the money to get their operation up and running. Subsequent funding can be raised after the business has started achieving some of its key performance indicators, such as certain revenue targets or the size of the user base.
This round is characterised by start-up founders developing a strategic plan and business model that will lead to future high growth, highlighting reasons and future incentives to attract investment. Equity crowdfunding is common at this stage, as are multiple VC firms coming on board to help start-ups achieve the next level of growth and development.
Series B focuses on pushing start-ups beyond developmental phases. This funding helps companies to achieve the new levels of demand, preparing them to succeed on a greater scale.
Later-stage companies attract hedge funds, private equity firms and investment banks with their proven model, growth history, healthy revenue streams and established customer bases. Investors inject capital to assist with market expansion, acquisitions, new product development and more. In essence, this funding round aims to scale a business quickly and successfully.
While there is no specified number of rounds that a private company must go through before it sells public shares on the stock exchange, typically it’s three. Rather than complete an IPO, some may opt for Series D, or even Series E, funding to raise funding a fourth time.
By definition, venture capital encompasses the money, technical or managerial expertise provided by investors to start-up firms with long-term growth potential. Many only associate VC involvement with the funding aspect of the relationship when, in fact, it often goes beyond this.
It’s no secret that capital sourced from angel investors and other sources can be transformative for tech companies. However, the nature of VC financing – and its distinction from more-traditional, corporate venture lending – means it is well-placed to add a huge deal of value beyond money alone. Start-ups operate in constantly evolving, fast-paced environments which feature emerging technologies, uncertain projects, unestablished product and service offerings and often-ambiguous customer demands. In this space, the guidance and expertise of more-experienced financiers and business people can be game-changing.
The high failure rate of most tech start-ups – approximately two in three – highlights the fact that venture capital funds alone are not always enough for entrepreneurs to succeed. Instead, greater, varied, and more holistic input is needed from VC firms in order for them to have the best chance of success and, in turn, the best chance of returning higher profits.
The potential impact and influence of VCs in their portfolio companies goes far beyond straightforward financial backing. Research indicates that VC funds can accelerate growth and development across a broad spectrum of business areas, known as the TOPSCAN framework:
- Team building – support with the design and recruitment of a start-up’s employees: its most important asset.
- Operations – improvements to various capabilities, including technology, administrative, legal, accounting and sustainability.
- Perspective – strategic guidance to help a start-up to define its target audience and markets, product and service offerings, and competitive positioning.
- Skill building – ensuring that the human capital, in particular the senior management team, have the required skill sets to run, develop and scale the business.
- Customer development – support to identify and access the target demographics and markets.
- Analysis – early-stage businesses must understand how to measure, interpret and report on their performance.
- Network – in many ways the simplest and cheapest means to add value for entrepreneurs, helping them to tap into existing industry networks – including potential future investors – can be invaluable.
In this way, investors play a “value-creation” function in a company’s growth – with numerous opportunities across the company’s ecosystem in which to share expertise, resources and industry insight. All are critical accelerators that start-up founders and co-founders may find it difficult, even impossible, to achieve otherwise. Throughout the process, VC financiers can offer to act as mentors and in-house experts, supporting decision-making efforts and helping entrepreneurs to realise ambitions.
Of course, not all VC investors may want, or have the capacity, to address all of the value-creation bases and offer the commitment and resources they require. As such, it may be more prudent for investors to focus on a specific aspect of their role. For example, some may act solely as financiers, others as mentors, and others as portfolio managers and operators. This will very much depend on the time and ambitions involved, as well as the relationship between investor and entrepreneur. It involves an understanding of individual assets, including how to leverage strengths, and offset weaknesses.
Regardless of the dynamic, VC plays a pivotal, transformative role in both the financial system and the shaping and growth of start-ups.
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