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Your Complete Guide To Venture Capital Funding For Startups

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@eqvistaEqvista

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Venture capital is a term that is frequently thrown around when there is a startup in the house. While a lot of people know that it is a source of funding, not many know what venture capital funding is and how the process works. To begin with, startups that are looking for funding usually ask help from venture capital (VC) firms. Other than helping with capital, these firms also offer strategic assistance; introductions to partners, employees, and potential customers; and a lot more.ย 

But, obtaining the capital financings is not that easy. And the entrepreneur will be better prepared to obtain venture capital financing if they understand the process and the deal terms. This guide will help you learn all about it so that you are prepared for the process and deal with it in a better way.

What is Venture Capital?

Venture Capital is an institutional investment made into early-stage/startup companies. Here, ventures involve risks, since it has uncertain outcomes, in expectation of a sizable gain. And venture capital is the money invested in a business that has just started (which is a risk). These startups exist as an initiative but have a huge potential to grow, which, in turn, would help the investors get a sizable gain in return.ย ย 

The people who invest the money in the companies here are known as venture capitalists (VCs). Venture investment is made when a venture capitalist purchases shares of the startup and becomes the financial partner (and shareholder) in the company. Venture capital investment is also known as patient risk capital since it includes the risk of losing the money in case the company does not succeed. Moreover, it takes a lot of time usually for the investments to fructify.

Venture capital usually comes from people who have a high net worth. They come together forming an investment firm and then invest in small companies. Capital is invested in exchange for equity in the company, which is what makes VCs different from the lenders. This is actually a great option for obtaining money for a startup where they only have to give out shares in exchange and ensure that the company grows substantially.

Features of Venture Capital investments

The main features of venture capital investments are:

  • High Risk
  • Long term horizon
  • Lack of Liquidity
  • VC investments are made in innovative projects
  • Equity participation and capital gains
  • Suppliers of VC participate in the management of the company

Early Stage Financing

Early-stage funding means funding a company when it has just started. There are actually, three sub-divisions of this kind of funding as explained below:

  • Seed funding - This is a small amount that is given to the entrepreneur for being eligible for a startup loan and work on their idea to convert it into a business.
  • Startup funding - This is given to the companies for the purpose of completing the development of the services and products.
  • First-Stage funding - Companies that have spent all their capital and need more for beginning the activities at a full-scale get the First-stage funding.

Process of Getting VC Funding

Let us say that you want to get early-stage funding for your business. In this case, there are some steps that have to be followed. Here is all you need to know about the process to help you prepare for obtaining the capital:

Step 1: Submission of the Business Plan

The first step in approaching venture capital is to submit your business plan. Even if you are just in the idea stage or if you have already prepared the products and the services, you will need to have your business plan ready to share it with your investors. The plan needs to include the things as shared below:

  • An executive summary
  • A description of the opportunity and the market potential and size
  • Detailed financial projections
  • Review on the existing and expected competitive scenario
  • Details of the management of the company

Using this, the venture capitalists would do a detailed analysis of the plan and decide if they should take it up or not.

Step 2: Introductory Meeting

Let us say that they decide to take up the project. The next step includes a one-to-one meeting for the discussion of the project in detail. After the meeting, the VCs would make their final decision if they would like to move to the next step which is the due diligence stage of the process.

Step 3: Due Diligence

In this stage, the due diligence is based on the nature of the business proposal. The process involves solving the queries that are related to the management interviews, product and business strategy evaluations, customer references, and other such exchanges of information during this time period.

Step 4: Valuing the Company

The next step includes valuing the company. The valuation is a critical issue for both the VCs and the company. And this valuation is usually known as the โ€œpre-money valuation,โ€ which is the agreed-upon value of the company before the new capital/money is invested. For instance, if the investors want to invest $2 million where the pre-money valuation is agreed to be $8 million, this means that the post-money valuation would be $10 million. From this, the investors would expect to get about 2/10 or 20% of the company at the closing of the funding deal.

The valuation, in this case, is usually determined by the investors and it is negotiable. Since startups have just started out, their valuation usually falls between $100,000 to $5 million based on where it has reached. So, when the valuation is this low, the VCs and owners work on creating another deal, which comes in the next step.

Step 5: Form of the Venture Capital Investment

Since the startup does not have a huge value, investing in the company in exchange for shares initially is just not the right thing. That is why the investors usually invest in the following forms:

  • Convertible Notes: In this, the investors get a note by the company that would be converted into stock in its next funding round after it is valued then. The note usually has an interest rate on the amount, a discount on the share value when the conversion takes place, and a maturity date (when last it should be converted). It also comes with a cap on the value of the company at times for purposes of the conversion rate. They are common as the company does not have to be valued at this time and the investors get a lot of benefits as well.
  • SAFE (Simple Agreement for Future Equity): These are alternatives to the convertible notes. They are used the same way just that they do not have a maturity date and no interest. The rest of the features are the same where it comes with a discount and/or a cap as well and converts on the next funding round.
  • Convertible Preferred Stock Investment: Under this, the investors are given more preference than the common shareholders in case the company is sold. This means that they would be paid first always. The rules of the form are the same as the convertible note and convert into shares on the next companyโ€™s funding. Moreover, if the investor wants, they can easily get the shares converted to common shares as well.

Just to be clear, VCs usually do not like this option and tend to invest only when the company is in its first stage. But there are chances that you might be lucky if you have a great idea.

Step 6: Term Sheets and Funding

When all the formalities have been completed, the next stage is to get the term sheet ready. This is a non-binding document explaining the basic terms and conditions of the investment agreement. Using the above form or whichever deal decided, the term sheet is made after all parties have agreed. With this, the legal documentation and due diligence are completed. And then the funds are made available for the company.

Conclusion

Since there are a lot of risks that are involved in venture capital investments, it is important to study the case properly. If you want to take up the investment, you will need to work on preparing a plan that would help the company grow. And as you move ahead to give out shares of your company, just ensure that you are keeping track of all of them. The best way to do that is with the help of cap table management software.

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