For many entrepreneurs, venture capital is, as Elaine Benes would put it—an enigma, a mystery wrapped in a riddle.
Part of the mystery is due, at least in part, to the unique language prevalent in venture capital, such as “risk capital,” “carry,” and “post-money valuation.” Intentional or not, this language can create an uneven playing field for founders negotiating an investment.
Let’s unwrap the enigma of venture capital by taking a deeper look into what it is, who it is for, and how it works.
What is Venture Capital?
The National Venture Capital Association defines venture capital firms as:
“professional, institutional managers of risk capital that enable and support the most innovative and promising companies. Venture capital supports new ideas that:
1. Could not be financed with traditional bank financing;
2. Threaten established products and services in a corporation or industry; and
3. Typically require five to eight years (or longer!) to reach maturity.”
Venture capital is comprised of professional, institutional managers of risk capital.
Venture capitalists are professional investors that invest in high-risk companies, technologies, and industries, through one or more “funds.”
Venture investments are high-risk not simply due to the companies, technologies, or industries involved but also due to the investment structure.
Generally, venture capital investments are structured as equity investments (i.e., stock ownership).
Equity investments provide a residual claim on a company’s earnings and assets after all its obligations (e.g., wages due to employees) and liabilities (e.g., bank or trade debt, contractual obligations) are paid or performed.
Equity investments usually receive limited control rights (e.g., the ability to vote on the board of directors or sale of the business) and the ability to appreciate as the company grows.
Control and appreciation are centerpieces of venture capital.
For instance, venture capitalists use control rights to influence a business’s day-to-day operations through board seats and provide technical expertise, mentoring, and access to their networks to facilitate growth.
Venture capital enables and supports innovative and promising companies that could not be financed with traditional bank financing.
Venture capitalists invest in companies that do not have access to traditional commercial financing (e.g.,bank loans) due to the nature and stage of the business.
Remember, venture investments are focused on the appreciation of the investment (i.e., the value of the company going up).
However, banks and other traditional funding sources structure their investments to prioritize a return of capital and a fixed return.
For instance, banks provide loans that may have a claim on the assets of the company—being the principal of the loan and the accrued interest, but, in return, the bank has priority in the event things go sour (i.e., the bank gets paid back before the holders of equity).
Put simply, loaning money to a business makes sense if the bank believes that the company is likely to generate positive cash flow to pay off the interest and principal within a relatively short period (i.e., the maturity date).
Because these lenders only have a claim on the agreed-upon interest and principal that the company is obligated to pay—they do not have a claim to the upside beyond that fixed amount.
Compare this to an equity investment where the investor has a subordinate claim (e.g., no priority if things go sour) and is not promised repayment within a particular time but has an unlimited upside.
From an entrepreneur’s perspective, because granting equity gives the investor a level of control and a right to a portion of the upside, an entrepreneur may prefer to finance its operations with debt if it believed it could repay the debt within the time required by the loan and still grow at a sustainable rate.
But, unfortunately, companies ripe for venture capital are unlikely to generate positive cash flow in the short term—and even when they do, they are better off putting that cash back into creating innovative products or scaling into other markets.
Venture capital enables and supports innovative and promising companies that threaten established products and services.
Airbnb, Apple, Amazon, and Uber. Venture capital funded each of these companies.
Although these companies are different in many ways, they use technology to disrupt an industry that relies on outdated or inefficient practices or technologies.
Take Airbnb, for example–a business centered around people renting a room from a stranger on the internet.
Does this look like the type of business that a bank would be willing to loan money?
I imagine if Brian Chesky went to his local bank with the idea for Airbnb, the bank would have been more likely to fund the purchase of an apartment than a website that allows other people to rent out rooms to strangers on the internet.
At least in the former situation, Brian could provide information on how much he would pay on his mortgage, how much he would charge a renter, and how often he expects to rent a room to produce some type of financial projections demonstrating positive cash flow.
In the latter, Brian needs to include costs related to engineers, marketing, and customer service—just to produce any revenue—let alone demonstrate positive cash flow.
Airbnb’s success aside, this makes sense within the context of our previous discussion.
Because a bank only has a right to a fixed claim and no right to the upside, the risk-to-reward profile makes turning down Airbnb (in its early days) a wise decision for a bank.
Conversely, Airbnb’s business model makes sense in the context of venture capital due to its ability to scale.
Renting a room in an apartment building is not scalable—the maximum amount Brian can earn depends on the number of nights he can rent a room, the amount he pays on his mortgage, etc., and the price a guest is willing to pay.
On the other hand, creating a marketplace where individuals from around the world can host their apartments is scalable. However, reaching this scale requires substantial resources and is highly risky.
An investor will generally only take this risk if they can influence the growth of the business through some level of control and enjoy the upside in the company’s growth to accommodate the risk.
Venture capital enables and supports innovative and promising companies that typically require five to eight years to reach maturity.
Up to this point, we’ve described the “high-risk” nature of venture capital investments by pointing to (1) the structure (e.g., debt v. equity) and (2) the business model, but we’ve only alluded to another inherent risk–venture investments are illiquid.
Liquidity generally refers to the ease or difficulty of buying, selling, or exchanging assets in a marketplace. Typically, venture capital investments are equity investments (e.g., stock) in private companies that are not traded on a public exchange (e.g., NASDAQ).
Because equity investments are “securities,” they are subject to US securities laws, which generally prohibit the offer and sale of those securities until a company goes public by filing a registration statement or (more commonly) can find an exemption from registration.
However, few companies go public because of the expensive, time-consuming, and demanding compliance requirements.
Another option for liquidity is a sale of the company, which requires an interested buyer(e.g., acquisition by a competitor).
As an example of the illiquid nature of venture capital, let’s look again at Airbnb.
Airbnb was founded in 2008 and received a few notable investments: (1) in 2008 it received $20k from Y-Combinator, (2) in 2009 it received $615k from Sequoia Capital, (3) in 2010 it received $7.2M from Sequoia Capital and Greylock Partners, (4) in 2011 it received $112M from Andreessen Horowitz, (5) in 2012, it received $200M from Sequoia and Andreesen Horowitz, (6) in 2014 it received $475M from TPGCapital, (7) in 2015 it received $1.60B from TigerGlobal, and (8) in 2017 it received $1B.
Adding these rounds together with other debt and private equity transactions, AirBnB raised billions before going public in December of 2020, where it raised an additional $3.5 billion.
It was over 10-years before some of Airbnb's investors received a return, but when they did, that return was exponential compared to the investment.
Is venture capital for you?
With that briefer on venture capital, the question remains—is venture capital right for you? Well, this analysis starts by addressing the factors set out in the NVCA’s definition of venture capital.
(1) Can you generate sufficient cash flow to make monthly loan payments while still being able scale?
(2) Is the target market “big enough”?
(3) Do you anticipate exponential growth rather than steady and consistent growth?
(4) Is the nature of your business risky?
(5) Will it take a relatively long period before an investment is likely to “pay off”?
Depending on how you answer these questions, venture capital may be a potential funding source.
However, your ability to obtain venture capital funding and do so on favorable terms largely depends on your understanding of how venture capital works.
See how we explain venture capital.
Photos by: Donald Tran on Unsplash; Olav Ahrens Røtne on Unsplash; and Markus Winkler on Unsplash
Fine Print
This post should not be construed as legal advice for any particular facts or circumstances and is not meant to replace competent counsel. None of the opinions or positions provided are intended to be treated as legal advice or create an attorney-client relationship. This content may not reflect all current updates to applicable laws or interpretive guidance, and we disclaim any obligation to update this video.
