Many small-business owners wonder how venture capital (often abbreviated to VC) investment works and whether a venture investment is right for them. Here are three questions to consider:
- Can the business grow revenue fast enough to sustain a J curve? (Meaning that the business will grow so fast that it couldn’t possibly fund that growth with its natural cash flow.)
- Does it have an unfair competitive advantage?
- Am I willing to give up my autonomy over business decision-making?
That’s it. Everything else, even profitability, is a distant secondary consideration. If the answer to any one of those questions is no, venture capital investment is likely a non-starter for your business.
“True venture capitalists – not angel investors or family and friends, but institutional venture investors – are only interested in businesses that have [the] J curve attribute,” says Sean Ammirati, a lead partner at venture firm Birchmere Labs, the distinguished service professor of entrepreneurship at Carnegie Mellon University’s Tepper School of Business, and co-founder of CMU’s Corporate Startup Lab. If growing in a J curve, a business must get a capital infusion in the form of a loan or equity investment to cover the initial dip in the front of a capital J. That dip represents the initial negative cash flow, and the rest of the curve shows the exponential growth that is expected to follow.“For some businesses, the J curve may need a million dollars, and for others it’s hundreds of millions," says Ammirati. "But to get VC money, the business has to show that after losing a lot of money, it’s going to make a whole lot more in the future."
Sarah Fay, managing director of Glasswing Ventures, echoes Ammirati’s thinking: “We aren’t focused so much on profits. We think of value in terms of growth. We want to know there's a market need that's being met, that there's a real pain point a company is addressing, and that the capital we're providing is fuel to pour on the fire. So, not every business is right for venture capital.”
How Venture Capital Works
Venture capital refers to money that professional investors raise to make equity investments in businesses that they predict will provide high returns. Venture capitalists – and the pension plans, private foundations, and individuals that fund them – make money when the business is acquired or goes public. VC firms usually specialize in specific industries, geographic areas, or both. Because VCs seek very high returns they tend to invest in younger companies in growth industries, or those with the potential to disrupt traditional industries.
The nature of venture investing requires that each company a VC funds has the potential for extraordinary success. Ammirati likens venture capital investment portfolios to a stable of racehorses.“For every highly visible Kentucky Derby winner, the trainer has a bunch of modestly successful (and unsuccessful) runners back in the barn,” Ammirati says.
Even though a VC firm may invest in dozens of companies, its success is usually owed to one or two blockbusters over the course of decades.
According to The National Venture Capital Association’s 2021 Yearbook, there are about 2,000 venture capital firms in the U.S., . In 2020, these organizations
invested a total of $164 billion in 11,651 separate investment rounds.
VCs Work Through Specialization
Specialization is also key to how venture capital works, for both institutional VCs and angel investors. VCs specialize by industry and company type – a combination commonly called their “thesis” – and by investment stage, from pre-seed to pre-IPO (initial public offering).
“The most important thing to know about VCs is that they tend to be thesis-driven,” says Fay. “In order to make exceptional investments, you have to leverage your pattern recognition, and you can only have pattern recognition if you focus on specific stages and specific types of investments.When Glasswing launched, our thesis was built on the innovation wave around artificial intelligence technology. But we quickly narrowed our thesis to companies using AI to address specific opportunities in the business-to-business software-as-a-service space.”
Such intense focus enables VCs to build deep knowledge and networking connections to people in their chosen industries.
“VCs are networking animals," Fay says. We leverage our networks, and we build networks very purposefully, too, for deal flow. Then, once we've invested in a deal, we leverage our networks to help those companies succeed.”
Each VC firm usually also specializes in a particular investment stage, meaning the point in a business’s development at which the VC firm makes its first investment. The stages are Pre-Seed, Seed, Series A, Series B, Series C (and beyond).
“At each stage, the answers to the key questions VCs use to make their investment decisions are different,” notes Ammirati. "With a pre-seed company, VCs look for a compelling founder with a compelling idea that has great growth potential. At each successive stage, the demand for proof increases, in terms of the quality of the expanding senior management team, quality of the product or service being developed, the size of the potential market for it, and the number of customers and their level of commitment."
What Is an Angel Investor?
Since institutional VCs are defined as professional investment firms that spend mostly other people’s money, angels are best understood as the opposite: They’re individuals who have a different day job but invest on the side using their own money.
Ammirati and Fay both note, however, that specialization applies to angel investors, too.
“Angels invest in two types of businesses,” says Ammirati. “Businesses that they think they have some unfair competitive advantage to invest in, i.e., ‘I'm a doctor, I think I can invest in medical device businesses better than anybody else.’ Or businesses run by people in their professional network, i.e., ‘I live in Silicon Valley, I'm a tech CEO, I know lots of people starting businesses, I'm a pretty good judge of talent, I'll invest in the people I'm impressed with.’”
Angels are likely the main – maybe the only – type of venture investors who would consider small businesses of modest growth. Because they’re not beholden to anyone but themselves, angels sometimes have broader and more flexible reasons for investing. But they generally stick to businesses or people they know well.
To find an angel investor, Ammirati advises small-business owners to look within their own personal or professional networks.
“If you're starting a medical device company selling to orthopedic surgeons, and the local orthopedic surgeon in your town does angel investments, he or she is probably a realistic potential investor,” Ammirati says. "So is your dad’s college buddy who watched you grow up and does angel investments."
What Makes a Great Venture Capital Deal?
VC firms seek the same essential elements in every deal, but how those elements manifest themselves can be completely different depending on the industry specialization and investment stage.
According to Ammirati, those essential elements boil down to five things:
1. A Fantastic Team
Pre-seed, this may only mean the founder; in later stages, it means the senior execs followed by the teams beneath each executive leader.
2. A Large Market
Depending on the VC firm, a large market may vary from a total addressable market (TAM) of a few hundred million dollars to many hundreds of billions.
3. True Differentiation
The unfair competitive advantage (see more below).
4. Market Validation
This is always about customers and their satisfaction/experience, though the specific requirements vary from firm to firm and for different stages.
5. Fit With the Fund
The business matches the VC firm’s thesis and so can benefit from the firm’s network.
For many businesses, the trickiest of these elements to achieve is number three. That’s why one of the five core questions Ammirati asks every company founder looking for investment is, “If you are successful, what is your unfair competitive advantage?” While it’s rare for a pre-seed company to have a truly defensible unfair competitive advantage, “I need to believe that, if you execute successfully, it will be difficult for someone else to come along and replicate your success later,” says Ammirati. In later investment stages, the bar for a company to achieve number three rises.
Trading Autonomy for a VC’s Emotional Commitment
For many small-business owners, the hardest part of an equity investment is giving up control of the business they created. Whether a VC firm acquires a controlling or minority stake in the business, it will likely become a very proactive partner in managing it.
“Half the job of a VC is to figure out what to invest in; the other half of the job, especially for the lead VC, is to make sure what you invested in succeeds,” explains Fay.
That means VCs tend to stick with their companies. “VCs make a professional and frankly, more important, an emotional commitment that this business is part of what they're going to do for the foreseeable future,” says Ammirati.
Fay sums it all up: “This is why, for the right type of company, an investment from an institutional VC can be a huge advantage. It’s because of how far they'll go, not just providing capital, but to make sure you don't fail. Because your failure would be their failure, too.”
The Takeaway
Venture capital investment doesn’t work for everyone: Those 11,651 VC investments mentioned above amount to only 0.04%of the 32.5 million small businesses counted by the U.S. Small Business Administration for 2021. And that doesn’t even account for the possibility that more than one of those investments went to the same companies.
But for rapidly growing businesses with strong competitive advantages – and owners willing to share control – a VC can be a source of needed capital as well as a supportive partner with deep professional networks, all of which enhances a business’s chances for success.
Photo: Getty Images
