For many entrepreneurs, venture capital is, as Elaine Benes would put it—an enigma, a mystery wrapped in a riddle.
The unique language used by venture capitalists (VCs) creates part of the mystery.
What is Venture Capital?
The National Venture Capital Association (NVCA) defines VCs as:
Professional, institutional managers of risk capital that enable and support the most innovative and promising companies . . . 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.
VCs are professional investors that invest in high-scale companies, technologies, and industries, through one or more “funds.”
These investments are high-risk not simply due to the companies, technologies, or industries involved but also due to the investment structure.
Generally, venture 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 the company performs its obligations (e.g., wages due to employees) and pays its liabilities (e.g., bank or trade debt, contractual obligations).
Equity investments receive limited control rights (e.g., a board seat) 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.
VCs 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 appreciation (i.e., the company’s value going up).
However, banks and other traditional funding sources structure their investments to prioritize a return of capital and interest.
For instance, banks provide loans that may have a claim on the assets of the company (e.g., a lien)—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).
Loaning money to a business makes sense if the bank believes 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 claim to the upside, an entrepreneur may prefer to finance its operations with debt if they believe they can 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 may be 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 are all venture-backed companies.
Although different in many ways, each company uses technology to disrupt an industry that relies on outdated or inefficient practices or technologies.
Take Airbnb–a business centered around people renting a room from a stranger on the internet.
Does this look like the type of business a bank would be willing to loan money to?
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 what he pays on his mortgage, charges a renter, and how often he expects to rent a room to produce some financial projections demonstrating positive cash flow.
In the latter, Brian needs to include costs related to engineers, marketing, and customer service—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 for a VC 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 very 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. Venture 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 U.S. securities laws, which generally prohibit the offer and sale of those securities until a company files 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, $20k from Y-Combinator, (2) in 2009, $615k from Sequoia Capital, (3) in 2010, $7.2M from Sequoia Capital and Greylock Partners, (4) in 2011, $112M from a16z, (5) in 2012, $200M from Sequoia and a16z, (6) in 2014, $475M from TPGCapital, (7) in 2015, $1.60B from TigerGlobal, and (8) in 2017, another $1B.
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 substantially outsized the original investment.
Is venture capital for you?
With that briefer on venture capital, the question remains—is venture capital right for you? 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 to 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”?
Venture capital may be a potential funding source depending on how you answer these questions.
However, your ability to obtain venture capital funding and do so on favorable terms largely depends on your understanding of how venture capital works.
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Disclaimer: While I am a lawyer who enjoys operating outside the traditional lawyer and law firm “box,” I am not your lawyer. Nothing in this post should be construed as legal advice, nor does it create an attorney-client relationship. The material published above is intended for informational, educational, and entertainment purposes only. Please seek the advice of counsel, and do not apply any of the generalized material above to your individual facts or circumstances without speaking to an attorney.