Venture Capital (VC) Funding and Funds Explained

Mike ZaccardiUpdated August 19, 2022

Share this article:

Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

If you’re starting or expanding a small business, you may wonder what venture capital funding is, and whether it might be a worthwhile financing option to pursue for your venture.Venture capital (VC) is a type of financing that investors provide to startup companies and small businesses thought to have high growth potential. The funds generally come from well-off investors, investment banks, and other financial institutions. In addition to a monetary investment, VC backing often also comes in the form of technical or managerial expertise. Venture capital is typically only available to small companies with exceptional growth potential or that have grown quickly and appear poised to expand even more. Could it be an option for your venture? Read on to find out how VC funding works, plus the pros and cons of using venture capital to grow your business.

What Is Venture Capital or VC Funding?

Venture capital funding is a type of equity financing in which high-net-worth investors pool money together to invest in startups with high potential for growth. Equity financing is different from debt funding, such as different types of business loans. With VC funding, the money does not need to be paid back. However, in return for the investment, small business owners must give the venture capitalists some ownership of the company, along with a say over how it is run.

How Does VC Funding Work?

Many small businesses will seek a small business loan to start or expand their operations. But some startups can have difficulty getting financing, especially if they are selling a new product or service that may be seen as risky. And banks will often have minimum credit scores for business loans. In some cases, a new venture that has big growth prospects may be able to access VC funding to acquire the capital they need to expand quickly in exchange for equity in the business.The capital a venture capital fund provides to a small business often gets invested into building infrastructure the business needs to grow, such as manufacturing, marketing, sales, fixed assets and working capital.In addition to capital, many venture capital fund managers provide guidance to companies they invest in. VC firms are known for helping startups with recruiting employees, gaining customers, overcoming startup challenges, and access to follow-up funding.Recommended: Venture Capital vs. Private Equity: What’s the Difference?

What Are VC Funds?

Venture capital (VC) funds are pooled investment funds that manage the money of investors who are looking for equity stakes in startups and small businesses with high growth potential. These investments are generally characterized as high-risk opportunities, since many startups ultimately fail. A few home-run investments, however, can result in massive gains for venture capitalists, even if most of the startup investments go belly up. VC funding is a long-term proposition, however, with a time horizon of up to 10 years. Returns are generally distributed only after a liquidity event, such as an Initial Public Offering (IPO), acquisition, or merger.

How Do VC Funds Work?

To have a chance at getting VC funding, you generally need to be introduced to a venture capitalist by someone who knows both you and the VC fund. If the VC fund is interested, they will have a phone call with you. If they are still interested in your venture, they will likely ask you to submit a pitch deck or presentation. If the VC firm is still interested after your pitch or presentation, they may give you a term sheet, stating the terms of a possible funding offer. They will likely then do some investigations into your business and, if they decide to move forward, provide you with offering documents. The offering documents will state all the terms of their offer, including the amount of funding, the percentage of equity they will own, and other terms. If you accept the offer, funds will typically be transferred to your bank.Recommended: How Much Money Do You Need to Start a Business?

Investing in Venture Capital Funds

Investing in a venture capital fund is enticing, since these funds have the potential for high returns. But those returns are far from guaranteed. When comparing hedge fund vs venture capital investing, similar risks apply. Investors also need to be patient, since returns (if any) typically don't come until one or more of the companies in the portfolio has a liquidity event.In addition, to be able to invest in a venture capital fund you must be an accredited investor. To qualify as an accredited investor, you must have an annual individual income above $200,000 (or joint income above $300,000), a liquid net worth greater than $1 million, or hold the Series 7, 62, or 65 license.

Pros and Cons of Venture Capital Funding for Your Business

Finding a venture capitalist to invest in your business can give you the injection of capital you need to take your company to the next level. But there are strings attached. Here’s a look at some of the pros and cons of using VC funding to back your business.

Pros

You can get access to a large amount of capital
You will likely have access to valuable business expertise
Capital and expertise provided by a VC fund can lead to faster growth and success
You will also get networking benefits due to business connections

Cons

You will no longer have complete control over the company due to equity stake
You may end up with minority ownership
Getting venture capital funding can be a long and complex process
The benefits of VC funding are typically long-term rather than immediate

History of VC Funding

While VC funding dates to the 19th century, it didn’t become an established industry until after the Second World War. VC funds continued to thrive in the decades that followed the war, until the industry took a major hit from the 2008 financial crisis. At that point, institutional investors, who were the main source of VC funds, tightened their wallets. The emergence of the tech sector in the 1990s, however, brought new investors to the game, and VC investing gradually shifted from being centered in the Northeast to mostly happening on the West Coast.In late 2021, however, a lot of VC action shifted to the Midwest, and to Denver and Chicago in particular. While the number of West Coast deals is waning, the San Francisco Bay Area still dominates the VC world.

Alternatives to VC Funding

Not every small business meets the criteria to get VC funds. Fortunately, there are several other ways a small business owner can access capital to grow their firm.

Small Business Loans

Small business loans can be used for a variety of purposes. In addition, you don’t have to relinquish any equity in your business as you would with VC funding. Once you pay back your loan, your relationship with the lender ends. With term loans, you receive a lump sum of money then pay it back (plus interest) in installments over a set period of time (the loan’s term). Recommended: Startup Business Loans

Crowdfunding

Crowdfunding a business entails getting small contributions from a large number of people via a crowdfunding platform. It can serve two purposes: generating funds and also stirring up excitement about your business. Just keep in mind that it can take a lot of time and effort to create a successful crowdfunding marketing campaign. You may or may not have to pay back crowdfunding financing depending on the type of crowdfunding.

Angel Investors

Finding angel investors is another potential funding avenue for a small business. An angel investor is typically a high-net-worth individual who offers financial backing for small startups, typically in exchange for ownership equity in the business. Angel investors could be knowledgeable and wealthy industry experts, but they might also be just friends and family who want to help.

Lantern Small Business Loans

Venture capital funding can help some small promising businesses acquire the capital they need to grow. However, if you’re not eligible or interested in venture capital financing, you may want to explore other types of financing for your business. With Lantern by SoFi’s online lending platform, it’s easy to compare loans for small businesses that are matched to your company’s needs and qualifications. It takes one short application and you don’t need to make any type of commitment.

Frequently Asked Questions

Is VC funding typically a loan?

Can you invest in a venture capital fund?

Are venture capital funds safe investments?

Photo credit: iStock/FlamingoImages

LCSB0622009

About the Author

Mike Zaccardi

Mike Zaccardi, CFA, CMT, is a finance expert and writer specializing in investments, markets, personal finance, and retirement planning. He enjoys putting a narrative to complex financial data and concepts; analyzing stock market sectors, ETFs, economic data, and broad market conditions; and producing snackable content for various audiences.

Share this article: