Venture capital to finance innovation in startups

Venture Capital (VC) has been a fundamental pillar in the creation and expansion of some of the world’s largest companies. Venture capital funds have become the primary alternative for startups that do not have a financial track record to back them up.

As an entrepreneur of a newly created company, you can find various sources of financing in your environment, ranging from bank financing to alternative channels such as friends and family, business angels, crowdfunding, VC, stock market, etc. (Ruano, 2018).

However, if you request a loan from a traditional bank, they will probably ask for a series of documents and guarantees that, as a startup, you do not yet have.

If your company is ready to grow and lacks a track record to support your cash flows, it is important to start considering the possibility of seeking financing from a venture capital company.

This article explores in depth what venture capital is, how it differs from other forms of financing, the benefits it offers, and why it is crucial to understand its role in the startup ecosystem and beyond.

Importance of Venture Capital (VC)

As described by Zider (1998), risk capital plays an important role in the next stage of the innovation life cycle, the period in the company’s life when it begins to commercialize its innovation and, therefore, does not yet have sufficient revenue to finance its growth.

In this sense, Bellucci et al. (2021) highlight that investments in venture capital can constitute an important alternative instrument for young and innovative companies that encounter barriers in traditional financing (e.g., bank loans).

In this regard, studies by Bernstein et al. (2015) demonstrated that the involvement of venture capitalists with the companies in their portfolio leads to an increase in innovation and the likelihood of a successful exit.

Venture capital investments have increased significantly between 2008 and 2018, from EUR 30 billion to EUR 380 billion worldwide (Bellucci et al. 2021), and today, the promotion of these types of funds is part of the policies of some countries.

What is Venture Capital or Risk Capital?

It is common for venture capital (VC) to be translated into Spanish as “capital riesgo”; however, it is important to note that VC is only one type of risk capital. It is also known as “entrepreneurial capital.”

Venture capital is a type of private financing that investors provide to small, emerging companies with high long-term growth potential. These companies are usually startups that need capital to scale their operations, develop innovative products, and carve out a market presence. In this regard, Ruano (2018) describes venture capital as the most suitable tool for financing newly created companies with high technological content and scalable business models that allow them to pursue ambitious growth plans.

Unlike other forms of financing, such as bank loans, VC does not require the immediate repayment of capital. Instead, investors receive an equity stake in the company and expect to benefit when the company grows and is sold or goes public (IPO).

Venture capital is a type of financial operation where capital is provided to startups and companies with high growth potential and high levels of risk in exchange for a percentage of the company (Novoa, 2019). However, it is important to note that it is not just about financing but also about providing advice and offering networks of contacts.

On the other hand, Peiro (2015) highlights that “Venture Capital” refers to all those equity investments used to finance small or medium-sized companies, typically startups.

It is important to note that entrepreneurial capital is a type of risk capital, primarily oriented toward seed capital, startup, and “late-stage” capital (Ruano, 2018).

Metrick and Yasuda (2021) report that venture capital has five main characteristics:

1. It is a financial intermediary, in the sense that it takes capital from investors and invests directly in a portfolio of companies.
2. It only invests in private companies.
3. It has an active role in monitoring and helping the companies in its portfolio.
4. The main objective of venture capital is to maximize financial returns from the success of its investments through an initial public offering (IPO).
5. It invests in the internal growth of companies.

What is a Venture Capital Fund?

A venture capital fund is an investment vehicle that pools capital from multiple investors to invest in startups and emerging companies. These funds are managed by venture capital firms, which identify and select promising investment opportunities. The goal is to generate significant returns for investors by investing in companies with high growth potential, often in technology and disruptive industries.

Who is a Venture Capitalist?

You’ve likely come across the term “venture capitalist” while researching venture capital.

A venture capitalist refers to the investor, or in other words, the risk capital investor who manages the operations of the entrepreneurial capital fund.

Metrick and Yasuda (2021) describe that the main activities of a venture capitalist can be grouped into three categories: investment, monitoring, and exit. In this regard, Zider (1998) highlights that the venture capital industry has four main players:

• Entrepreneurs who need funding;
• Investors who seek high returns;
• Investment bankers who need companies to sell; and,
• Venture capitalists who make money by creating a market for the other three.

Stages of Venture Capital

To give you an idea of how a VC fund works, Peiro (2015) and Rodríguez et al. (2015) describe the following stages of a venture capital initiative:

1. Fundraising: This stage typically lasts between 6 months and 1 year. The venture capital firm seeks funds from investors, but they are not yet invested. During this stage, fund managers usually dedicate themselves exclusively to raising resources from different sources.
2. Sourcing and Selecting Investment Opportunities: Once the venture capital fund has secured new investors, it begins searching for investment opportunities. Fund managers gather information on business opportunities. This stage can last up to five years.The initiatives are evaluated on five dimensions: i) Market attractiveness and business environment ii) Product differentiation iii) Managerial skills iv) Resilience to threats v) Exit options.
3. Investment Commitment: At this stage, decisions are made about which companies to invest in and how much of the fund will be allocated to each one. The funds are invested in companies, which, as a general rule, usually do not generate positive returns. This stage typically overlaps with the previous stage and usually lasts between 3 and 5 years.
4. Investment Management: At this stage, all the capital has been invested. This is when the VC firm begins managing the portfolio of companies and leveraging business knowledge and experience. The funds dedicate much of their activities to monitoring and tracking the companies to ensure that the established goals are met. During this stage, the investment starts to yield returns, and an exit plan is developed.
5. Fund Liquidation: The fund is closed, and the profits are distributed among the investors and the venture capital firm (fees). There are five main exit mechanisms: i) Initial Public Offering (IPO) ii) Strategic sale iii) Management buyout iv) Secondary sale v) Liquidation.

How Does Venture Capital Work?

The venture capital process follows several stages, each aligned with the startup’s lifecycle:

• Seed Funding: The first round of financing, where investment is made in initial ideas or prototypes.
• Early Stage Funding: Financing for companies that have already developed a minimum viable product (MVP) and are beginning to attract their first customers.
• Growth Stage Funding: Investment in companies that are growing rapidly and need capital to scale their operations and capture a larger market share.
• Exit Strategy: The exit strategy for investors, which typically occurs when the company goes public (IPO) or is acquired by a larger company.

Advantages and Disadvantages of Venture Capital

Due to its business model, VC not only provides financing, but its money comes with various value-added services such as contacts, advice, incentives, interpersonal relationships, and reputation (Ruano, 2018).

In this regard, Jeong et al. (2020) emphasize that the contribution of intangibles from venture capital companies is critical because young companies often lack financial and intangible resources, including experience and knowledge, necessary to develop their businesses.

In this sense, venture capitalists are not passive investors; due to their equity stake, they are interested in the company’s success (Kenney, 2015). In their study, Bellucci et al. (2021) highlight that venture capital investments have positive effects on company growth, in terms of total assets and the number of employees, while mixed results arise when analyzing total sales.

Kenney (2015) also notes that the involvement of a VC depends on the situation and the agreements reached, but typically includes advice on strategic decisions, assistance in hiring key personnel, and providing contacts in the legal, banking, and business services communities.

In summary, the main benefits of venture capital include:

• Access to Expertise and Networks: Venture capital funds are often led by former entrepreneurs and industry experts who can provide strategic advice, key connections, and access to a valuable network of contacts.
• Accelerated Growth: With the infusion of capital, startups can quickly scale, expand their team, improve their technology, and increase their market share.
• Validation and Credibility: Securing funding from a reputable venture capital fund can be a positive signal to other investors, partners, and potential customers.

As you can see, there are several advantages; however, what are the disadvantages?

The main disadvantage of receiving entrepreneurial capital funds is the loss of decision-making power within your venture. If you were previously the sole decision-maker, you will now have to consult with your “partner.” In this sense, the main disadvantages of venture capital are classified as:

• Dilution of Ownership: By receiving funding, the founders of the company give up a portion of control and ownership of their company, which can be significant in successive funding rounds.
• Growth Expectations: Venture capital investors often have high growth expectations, which can put pressure on the founders to quickly achieve ambitious goals.
• Risk of Failure: VC invests in high-risk companies, and not all startups achieve success. Statistics show that a large portion of venture capital-funded startups do not reach their potential, resulting in losses for investors.

What Makes a Company Attractive to Venture Capital?

Venture capital funds look for certain key characteristics in startups before investing:

• Market Potential: Companies operating in large and growing markets are more likely to attract venture capital.
• Innovation: Startups with disruptive products or services that have the potential to change the industry or create a new market.
• Founding Team: A founding team with experience, complementary skills, and a proven track record is a decisive factor.
• Scalability: Business models that can scale quickly, with profit margins that expand as the company grows.

Difference Between Venture Capital and Other Forms of Financing

In addition to private equity, it’s useful to understand how venture capital differs from other forms of financing like bank loans, grants, and crowdfunding:

• Bank Loans: Require repayment of principal with interest, regardless of the company’s success, whereas venture capital does not demand repayments but involves giving up equity.
• Grants: Generally awarded by governments or institutions, grants do not require repayment or equity participation, but are often limited to certain types of projects.
• Crowdfunding: Allows startups to raise funds from a large number of small investors, often in exchange for rewards or minority stakes.

Venture Capital vs. Private Equity

Private equity and venture capital both aim to help companies achieve growth by providing financing, strategic advice, and insights; however, they are two different types of financing based on a company’s life cycle.

Dziekoński and Sławomir (2015) indicate that venture capital is a subset of private equity, referring to equity investments made for the launch, initial development, or expansion of a business.

The venture capitalist provides funds for startups and early-stage companies, while private equity operators are involved with deals with more mature companies (Dziekoński and Sławomir, 2015).

Table 01 gives you a clear view of the main differences and similarities between Venture Capital and Private Equity, helping you better understand when and why to use each one depending on the business context.

Table 01. Comparison Between Venture Capital and Private Equity.

The Venture Capital Market

Bellucci et al. (2021) highlight that venture capital fund investments reached EUR 380 billion worldwide; however, U.S. and Chinese companies are the main focus for investors, accounting for approximately 80% of global value in 2018.

There are several venture capital funds operating under the VC model. You can use the Venture Capitalista Database tool to find examples of venture capital, and to obtain information on companies and the sectors they finance in European countries, China, Canada, Russia, and the U.S.

Additionally, if your interest is solely in the U.S. market, you can visit the website of the National Venture Capital Association (NVCA), which brings together the U.S. venture ecosystem to support the formation of high-growth companies.

Current Trends in Venture Capital

The venture capital landscape is constantly evolving, influenced by technological, economic, and social trends:

• Focus on Green Technology and Sustainability: Increasingly, VC funds are investing in startups that address environmental issues, such as renewable energy, clean technology, and sustainability. In this regard, Benkraiem et al., (2023) emphasize the importance for corporate investors to include ecological considerations in their overall business strategies to create a competitive advantage.

• Geographic Diversification: While Silicon Valley remains a hub for VC, other markets like Asia and Europe are seeing a rise in venture capital activity.

• Inclusion and Diversity: There is a growing interest in investing in startups founded by women and minorities, recognizing the need for greater diversity in the entrepreneurial ecosystem.

Conclusions

Venture capital has proven to be a transformative force in the business world, enabling innovative startups to become industry giants. Understanding what venture capital is, how it works, and the key differences between it and other forms of financing is essential for any entrepreneur or investor looking to successfully navigate the world of entrepreneurship.

Finally, you must consider whether it’s worth giving up some control in exchange for the funds (and advice) you need to bring your innovation to market and make it successful. What do you think?

References

Bellucci, A., Gucciardi, G. and Nepelski, D., Venture Capital in Europe. Evidence-based insights about Venture Capitalists and venture capital-backed firms, EUR 30480 EN, Publications Office of the European Union, Luxembourg, 2021, ISBN 978-92-76-26939-7, doi:10.2760/076298, JRC122885.

BERNSTEIN, S., GIROUD, X. and TOWNSEND, R.R. (2016), The Impact of Venture Capital Monitoring. The Journal of Finance, 71: 1591-1622. https://doi.org/10.1111/jofi.12370

Benkraiem, R., Dubocage, E., Lelong, Y., & Shuwaikh, F. (2023). The effects of environmental performance and green innovation on corporate venture capital. Ecological Economics, 210, 107860. https://doi.org/10.1016/j.ecolecon.2023.107860

Dziekoński, Krzysztof; Ignatiuk, Sławomir (2015) : Venture capital and private equity investment preferences in selected countries, e-Finanse: Financial Internet Quarterly, ISSN 1734-039X, University of Information Technology and Management, Rzeszów, Vol. 11, Iss. 3, pp. 128-137, http://dx.doi.org/10.14636/1734-039X_11_3_010

Jeong J., J. Kim, H. Son and D. Nam. 2020. The Role of Venture Capital Investment in Startups’ Sustainable Growth and Performance: Focusing on Absorptive Capacity and Venture Capitalists’ Reputation. Sustainability 2020, 12, 3447; doi:10.3390/su12083447

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