Hi! Whether you’re in the works of creating a game plan for how you’re going to fund your business or you simply have an idea that you’re hoping to make profitable, reading this is a great first step to understanding some basics of entrepreneurship. I couldn’t think of a better way to kick off this new finance series other than by going over some of the ways startup companies and small businesses find funding. I’ve touched on this briefly before, but I wanted to clearly address what venture capital is and explain how it differs from private equity. Let’s dive in! I should also say that this guidance is meant to be very general, and to help break down concepts into digestible and easy to understand elements.
Venture capital is a type of private equity where groups of investors pool funds together to be managed by a venture capitalist (an individual) or a venture firm. Once a venture capital fund has been formed by a pool of investor capital, it usually operates with a specific focus and will last for a certain timeframe, like seven years, for example.
Who is venture capital for?
Deciding how to fund your business is an extremely personal decision, but venture capital is traditionally for start-ups that require some level of significant capital infusions to expand, scale, or launch on the market. Venture capital requires the potential for scale (i.e. reaching a vast number of potential customers) whereas a company that is more of a lifestyle business doesn’t require the same type of investment because those kinds of businesses can’t achieve the same degree of scale.
Why does the timeframe matter?
If you’re an entrepreneur and you want to raise venture capital funds, you need to understand the length of the fund you’re targeting. Let’s pretend you’re starting a jam company and you know that you need 1 million dollars to open three stores over the next four years in order to hit your goal. That would mean you need four years to take on capital, deploy it toward your vision, and see results. If a fund is in year five of its seven-year lifespan then the fund and your business are fundamentally incompatible. You need to target a fund that has at least four years remaining in its time horizon.
Where does venture capital come from?
Venture capital most often comes from wealthy investors, investment banks, or other financial institutions. You might think that it could be risky for investors, but the potential for above-average returns is what makes it attractive to them in the first place. For new companies that have a short operating history, like under two years or so, venture capital funding has become an increasingly popular source for raising capital. It’s important to keep in mind that one of the biggest disadvantages to using venture capital is that the investors typically get equity in the company, meaning they have a say in some of your decision making.
So, what’s the difference between venture capital and private equity?
Private equity is an umbrella term referring to the practice of institutional or accredited individual investors using capital to buy companies, make them better, and sell them. Venture capital refers specifically to shorter investment periods, and earlier stage companies—it’s a part of the private equity landscape.
We’ll get more into private equity in another post, but this should give you a sense of their main differences. And, as always, if you have any questions or want me to go into more detail on this topic, please drop a comment below.
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