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Why Do Startups Prefer A Venture Capitalist?



Portfolio investor. Businessman with briefcase | Why Do Startups Prefer A Venture Capitalist? | featured

Why do people want to become venture capitalists? At this stage, it’s not about just the money anymore. There’s easier money to be made in other safer investments like trading in stocks or bonds.

The thrill is definitely there in helping fund a new business, but it’s high risk and high reward scenario that isn’t for anybody. 

RELATED: Understanding The Venture Capital Gender Gap

What is A Venture Capitalist?

Businessman holding one hundred dollar bills concept for paying-Venture Capitalist

There are a million business ideas out there, and many come from brilliant minds that lack one obvious thing: capital. After all, it’ll take money to make even more money in today’s business environment.

To make these dreams into life, they’ll need a partner to help with the finances. That’s where the venture capitalist comes in. 

By definition, a venture capitalist is a person or company that puts up the money for use in a startup business. IN return, they get equity in the company.

If the company makes it, the VC gets rewarded with a high rate of return for their investment. If the venture flops, the VC sighs and looks for a new startup to help.  

Take note that a venture capitalist doesn’t necessarily have the money to fund startups. Most VC firms raise their funds from a combination of various sources.

They also invest their collective funds in other markets to grow as they search for potential companies. A single VC fund can run up to a hundred million dollars.

This money is usually invested in dozens of startup companies, although there are VCs known to plunk their entire fund in one promising venture. 

Why Do Startups Need Venture Capitalists?

Startups usually have more ideas than funding. While a business loan is a more direct solution, banks do not usually give out loans without collateral.

Meanwhile, many startup companies start with a bare-bones operation. Everybody has their own computer, they meet in a member’s garage or studio apartment, etc.

Taking out loans, which usually charge between 10-20% interest, becomes a difficult feat when nobody’s qualified to do so. 

In addition, some startups will require bigger amounts of money that banks won’t give up willingly. That’s where venture capital comes in.

In exchange for a piece of the company, VCs can provide funds to keep the startup in operation. 

How Much Do Venture Capitalists Make in A Startup?

VCs make money by investing in many startups. Putting all your eggs in one basket requires a very, very reliable basket. If there’s none, scattering the eggs into multiple baskets will at least ensure some will survive the trip.

Venture capitalists go by with the Babe Ruth rule: a single homerun can make up for the string of outs and strikeouts. 

Many startups don’t sell out controlling interest, so a number between 5% to 49% is usually the equity VCs demand.

They have their accountants sit down to establish the value of a company and give out funding that they think is equal to the equity they’re asking for.

It’s always cheaper to invest in a venture in its earliest stages. That’s where the biggest risk lies, and that’s also where the biggest payouts are. 

Returns usually happen in an inverted pyramid. Losses and bankruptcies happen for the majority (90% of all startups fail).

A middle portion where less than ten make it and payout 1x to 10x returns. And there are the home run hitters. These are 1 or 2 startups that actually break out and own the market.

These bad boys give out 50 to 250x multiples by the time they’re doing an IPO. Of course, the money they make depends on the amount they’re investing.  

So Why Is It Hard To Become A Venture Capitalist?

Like many businesses, venture capitalist hierarchy works under a hyper Pareto principle called power-law distribution. The top venture capitalist will offer the best returns compared to all other VC firms below it.

Whether as an employee or as an investor, you will find it very difficult, if not impossible to get into these top VC firms. 

Watch the Bridger Pennington video explaining the basics of Venture Capital:

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