What is venture capital? A guide for small businesses

What is venture capital?

It could be the rocket fuel you need if you want your business to be the next big thing.

Venture capital funds pump billions into the UK economy each year, funding young companies with strong potential growth and helping them on their journey to become major brands.

Many of the world’s best-known companies started with venture capital funding, including Microsoft, Amazon, Apple, Facebook and Google.

The UK has many confident venture capital providers too and can give Silicon Valley a run for its money.

Deliveroo, Moonpig, Skyscanner, Wise and Revolut are just a few stratospheric UK brands that received a kickstart from this form of funding.

One key attraction of venture capital funding is that it comes from specialist companies who are happy to take the risk of funding young companies that are often pre-profit, or even pre-revenue, and support you with expertise as well as funding.

This article explains what venture capital is, the pros and cons for companies, the stages of funding, and how it compares to angel investment and private equity investment.

Here’s what we cover:

• What is venture capital?
• How venture capital works
• Advantages of venture capital
• Disadvantages of venture capital
• Types of venture capital funding
• The difference between angel investing and venture capital
• The difference between venture capital and private equity
• Final thoughts: Venture capital is a challenge but could send your business into orbit

What is venture capital?

The British Private Equity and Venture Capital Association (BVCA) defines venture capital (VC) as a form of investment for early stage, innovative businesses with strong growth potential.

Alongside financial support, VC providers can offer you mentoring, operational expertise and access to their professional connections to help you find talent and advice.

VC is often aimed at young companies in technology-based sectors such as life sciences or fintech, but it could be relevant for any sector.

Andrew Shepperd, co-founder at Entrepreneurs Hub, says venture capitalists are typically most attracted to companies that disrupt big markets, such as fintechs, renewable and sustainable energy, medtech and healthtech.

Subscription or recurring revenues with sticky customers are especially attractive, but they are also interested in companies with patentable ideas or innovative services.

Businesses that are capital intensive, such as manufacturing, or sectors such as food startups, may find it harder to raise VC if they require more investment or carry more risk, he says.

How venture capital works

Startups often receive funding via angel investment, crowdfunding, grants, loans, incubators or friends and family.

VC is typically for companies that have outgrown these types of funding and are looking at the next stage of expansion, though it can often happen alongside these other investment types.

VC firms offer funding in exchange for a minority stake in your business. They typically offer money in ’rounds’ – Series A, B, C and so on – to support the company as it grows.

These further investments may come from the same provider and or new ones.

Venture capital providers, sometimes referred to as houses, will typically hold their investment in your firm for between five and seven years.

After this, you might look at further types of investment, such as private equity, acquisition by a larger company, or a stock exchange listing.

Advantages of venture capital

Venture capital can help your business scale quickly.

VC-backed companies are often between startup and expansion stage, and have huge growth potential but need funding to achieve it.

They may have little or no track record, so are relying on investors willing to take a significant risk, but who understand how to help companies in this critical phase.

You can use VC money for anything that will fuel your growth, from new machinery or technology to employing staff, product development, and setting up your marketing and sales operations.

Andrew says: “The main advantage of VC is access to the capital necessary to grow and scale your businesses.

“But venture capitalists often bring valuable experience and expertise too. They can guide and mentor your leadership team, significantly increasing your chances of success.

“The investor’s network and connections can open new opportunities and partnerships. And VC investment also helps small companies gain credibility and attract further funding from other investors.”

Disadvantages of venture capital

VC investment involves giving up a portion of ownership and control of your company.

Depending on your stage, prospects, the size of the investment, and the relationship with the investor, VCs can look to take between 25% and 50% of your company.

So consider carefully how much you are willing to give up and negotiate as hard as possible.

Andrew says that, though the investors take a minority stake, you may already have other investors or will need more in future.

So later dilutions can be the main pitfall.

Be very careful not to end up losing control of your business as you go through multiple funding rounds, or becoming significantly diluted so you only have a minor share of the later success.

It’s worth taking advice on this from the start.

VCs also often want influence over the decision-making process and sometimes a seat on your company’s board.

This could lead to a loss of control for the founders too, says Andrew.

Another potential pitfall is that VC firms may pressure you to achieve rapid and aggressive growth targets, which could force strategies that prioritise short-term results over long-term sustainability.

So it’s essential to establish before the deal that your goals and timelines can align with your investor’s.

At the least, VC investment means you’ll have another stakeholder who wants to scrutinise your business in detail before and after the deal. You’ll need to meet their reporting and transparency requirements, and they’ll likely want regular updates on the company’s financials, progress and strategy.

This creates an administrative burden that can take up valuable time and resources.

If you research your new investors carefully, and all goes well, the relationship should remain positive throughout the investment term. However, there’s potential for disagreements about strategic decisions, exit strategies, or the company’s overall direction.

Arbitration processes for handling any significant disputes should be mapped out before the deal.

Taking on VC involves sharing sensitive business information with investors, so make sure there are tight controls to avoid competitive intelligence leaks or intellectual property theft.

Not all venture capital investments experience these disadvantages, and relationships between investors and investees can vary greatly.

The key is to consider the pros and cons of VC funding for your firm as carefully as possible, and assess whether you and your investor’s long-term goals, timing, culture and vision align.

Types of venture capital funding

Venture capital funding often happens in rounds as your business matures. These are often described as seed followed by Series A, B, C funding, and so on.

The BVCA defines potential stages as follows:

• Seed: Helps you test, develop and prove your concept. It may include investing in research, prototypes, or business planning before bringing a product or service to market.
• Startup: For product development and initial marketing, for example. Investees may be setting up or in business for a short time, but have not yet sold their product commercially.
• Early stage: For companies that have developed a product but need more funding to start commercial manufacturing and sales.
• Late-stage venture: If you have reached a fairly stable growth rate. You may not be profitable yet, but you are more likely to be.
• Expansion: If you are trading profitably. These later stages could support growth through additional working capital, production capacity, and marketing or product development.

Andrew says seed and early stage funding may provide the capital you need to kickstart your business, but it will require you to give up a larger portion of equity.

Later-stage funding won’t dilute your capital as much because your business model is more proven and carries less risk.

But leaving it later may mean you have to raise larger amounts.

You should therefore consider your funding needs carefully before jumping into venture capital and do it later if possible.

Andrew also advises thoroughly researching potential investors and ensuring you understand the proposed deal.

He says: “Look at their past investments and reputation, and speak to other investees.

“Get legal advice to understand the terms and conditions of the investment, including the targets and timelines. Seek funding from multiple investors to create competition and secure better terms.”

Investors look at hundreds of pitches, so prepare yours as well as possible and be ready for rejections.

Andrew adds: “It doesn’t necessarily mean you’re a bad investment, it may just be there not the right investor for you.”

The difference between angel investing and venture capital

Angel investing is another type of early stage funding.

It also involves exchanging investment for equity in your business. But an angel investor is typically a wealthy individual or group of individuals using their personal finances.

By contrast, venture capital is provided through a fund managed by a firm that specialises in that type of investment. It gets its funding from various sources, including individuals, private banks, and other financial institutions.

Due to the higher risks involved, angel investing typically involves smaller amounts and happens at an earlier stage.

Most angels invest up to £50,000 in one round; and VCs usually invest between £50,000 and around £2m, but it could be more.

According to the UK Business Angels Association, angels are typically more personally involved than VCs, often acting as mentors and or taking a role on your board. They’re also more patient and less concerned with rapid returns and exit.

The BVCA says angel investment and venture capital are both crucial funding steps, and it’s common for angels and VCs to invest alongside each other.

The difference between venture capital and private equity

The main factor when deciding whether to use venture capital or private equity is the age of your company.

Private equity will typically invest in a mature company that has been in operation for years, and has a proven model and record of profits.

Venture capital firms invest in newer companies, many of which are pre-profit but have strong growth prospects.

Final thoughts: Venture capital is a challenge but could send your business into orbit

Seeking venture capital can be a thrilling challenge, but it’s hard work and time-consuming, and has several pitfalls to watch for.

A cautious and diligent approach is essential.

But VC has proven to be a critical driver of economic growth, investing billions into exciting young companies each year, providing valuable expertise and professional connections, and propelling many top brands into the stratosphere.

If you can make it the rocket fuel for your future success too, it will be well worth the challenges.