What is Venture Capital (VC)?

Venture Capital (VC) is financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. While it often grabs the headlines, it is a very specific type of funding tool designed for a very specific type of company.

Unlike a bank loan, venture capital is not debt. You do not pay it back with monthly interest payments. Instead, it is an exchange of equity. The investor gives you cash now, and in return, you give them a portion of ownership in your company. They are betting that your company will grow so large that their slice of the pie will eventually be worth exponentially more than their initial check.

To understand VC, you have to understand where the money comes from. Venture Capitalists are usually not investing their own money. They are investing money raised from Limited Partners (LPs). These LPs can be pension funds, university endowments, or wealthy families.

VC firms typically operate on a ten year cycle. They raise a fund, invest that capital into startups during the first few years, and then spend the remaining years trying to help those startups grow and exit. An exit means the company is sold or goes public (IPO). Because of this structure, VCs are on a clock. They need you to grow fast and exit within a specific timeframe so they can return profits to their LPs.

This is the most critical concept for a founder to grasp. The VC business model relies on the Power Law. This means that in a portfolio of ten companies, the VC expects many to fail completely. They expect a few to do okay and return the money invested. But they need one or two companies to succeed massively to pay for all the losses and generate a return for the fund.

Because of this, VCs are looking for home runs, not singles. They are not interested in a solid small business that generates a comfortable profit for the owner. They are looking for companies that can scale to hundreds of millions or billions in valuation. If your business does not have that potential, VC is likely the wrong financing route for you.

It is helpful to compare VC to a standard bank loan to see the difference in risk and control.

• Risk: Banks are risk averse. They require collateral and cash flow. VCs take on high risk. They invest in ideas and teams often before there is any profit.
• Upside: Banks limit their upside to the interest rate. VCs have unlimited upside if the company takes off.
• Control: Banks generally leave you alone as long as you make payments. VCs require active involvement. They often take board seats, require updates, and influence major strategic decisions.

Think of Venture Capital as rocket fuel. It is designed to make you go fast. If you put rocket fuel in a tractor, you will destroy the tractor.

Founders need to ask themselves if they want the pressure that comes with this money. Once you take VC dollars, you are committing to a high growth trajectory. You are signing up to report to a board of directors. You are agreeing to an eventual exit. It is a powerful tool for building world changing companies, but it requires giving up a degree of freedom.