When it comes to starting a new business, the word “risk” cannot and should not be taboo. On the contrary, you should know that an indispensable way of financing to bring a new startup to life is precisely the so-called “venture capital“. But why is it called that and what, exactly, do you risk losing? And why? To dispel any doubts, it is necessary, first of all, to clarify the precise meaning of venture capital.
Venture capital: definition
The definition of venture capital refers to that portion of capital contributed by the individuals who participate in business risk. This means that these resources invested within the company are lost and not distributed in the event of unfavorable events.
It should be made clear at this point that venture capital does not consist only of economic resources (i.e., in practical terms, liquidity), but one must also consider the experience, skills, and know-how that the financing partners might decide to make available to the company. All these resources could make the company’s fortune and, therefore, are quantified in venture capital.
Equity: meaning
In the last meaning mentioned above, venture capital mirrors what is known as Work for Equity, i.e., the possibility of remunerating consultants and external collaborators for their qualified professional services through shares, units or participatory financial instruments.
In economics and finance, the term equity overlaps with the term venture capital, also known as equity capital.
A further precision must be made, however: at the time of its incorporation, the company, for obvious reasons, cannot rely on its profits for its livelihood, and its initial capital consists of the shareholders’ contributions, the value of which is stated in the articles of incorporation. Later, however, the business will produce profits, and profit allocated to reserves and retained earnings will also be considered venture capital.
Venture capital and equity, therefore, do not properly identify the same thing: equity and venture capital coincide in the initial phase of the business but then, while the former remains essentially the same (unless a specific procedure is provided by the shareholders to change it), reserves and profits will increase and, with them, so will venture capital.
Instead, the parallelism between venture capital and net worth (another term by which “equity” is translated) seems more correct, All net worth, in fact, is subject to business risk and is therefore considered venture capital.
Venture capital: who are the investors?
Now that it is clearer for you what is meant by venture capital, you also need to know who the investors are. The main bearers of venture capital are meant to be the founding partners of the company. Even so, you need to know that there are a number of outside figures who can contribute to your startup’s venture capital.
Generally, the figure most sought after by startuppers is that of the Business Angel but, if your startup is “high risk” (but also has high development potential and is particularly innovative and, therefore, attractive), you could obtain funding from a Venture Capitalist: these are financial companies that specialize in high-risk investments, willing to offer very large sums of money and also provide knowledge and networks (often even internationally).
In addition to individual private investors and private finance companies, one must also consider the possible intervention of institutional investors in the public sphere (from the Italian state to the European Union, via other public bodies).
Finally, for many years now, the investment mechanism has also shifted to the web. Systems such as crowdfunding allow individuals to participate in the venture capital of startups that are already born or in the embryonic stage. This will then be referred to as equity crowfunding, or venture capital that is realized through public fundraising.
Risk capital: types
Just as there are different types of investors, there are also different types of venture capital investments. These are divided according to the life cycle of the company in which the investment occurs and the purpose of the investment.
Early Stage: investment in the starting phase of the enterprise
When venture capital investment occurs in the very early stages of a startup’s life (sometimes it may also occur in the so-called experimental phase, that is, when the product or service that is intended to be offered on the market is only a prototype) it is called seed financing and early stage financing. The purpose is to help launch the business and is a type of investment that is essential for the survival of the startup itself at the crucial moment when it begins to confront the market.
Expansion: investment under development
On the other hand, the investment made in the development phase (Expansion) is aimed at supporting the consolidation or indeed the development of a company already in the market, which, for example, aims to expand or enter new markets. In this case we speak of growth financing and late stage financing.
Replacement: investment undergoing change
Venture capital investment can also take place at a time of change for the company, and generally occurs when an investor takes the place (Replacement) of one or more exiting partners, in order to prevent the decision of one or more partners to disinvest from causing damage and holding back the company’s development.
Then there are other types including venture debt: these investments are loans that are provided to startups in exchange for guarantees or counter-guarantees, and corporate venture capital: these investments are made by existing companies that invest in startups to gain access to innovative technologies or to acquire new talent.
Venture capital or debt capital: what to choose
Be very careful not to confuse venture capital and debt capital: in fact, to choose between these two options, you need to know what they are and how they differ. Like debt capital, venture capital is also often composed of resources that come from third parties but, unlike the former (which remains the property of the third parties and therefore must be repaid by a set deadline and, often, with interest), the latter becomes part of the company’s actual assets. In other words, those who invest in venture capital become partners in the company and thus count on a return on their invested capital.
Now that you are clearer on the difference between venture capital and debt capital, there is one more thing you need to know in order to make a perfect funding plan and move successfully in this field. Peter Thiel, co-founder of Paypal and one of the richest men in the world, once said:
“A startupper needs to understand that success does not depend on the size of the budget they have. Spending money and solving real problems are two different things.”
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