Venture capital: how it works and how to attract it A guide to everything you need to know about raising venture capital funding for your startup or small business. Written by Stephanie Lennox Updated on 24 October 2023 Our experts We are a team of writers, experimenters and researchers providing you with the best advice with zero bias or partiality. Written and reviewed by: Stephanie Lennox Writer Guest Tips: Rob Tominey, CEO of Further Throughout this guide, we speak to venture capitalist expert Rob Tominey, one of the CEOs of Further. Further is a platform connecting all investors with venture capital, enabling more people to access the returns of startup investing, and the company featured in position #87 in the Startups 100 Index 2023. When it comes to the world of business financing, venture capital has always been seen as a powerful, yet slightly mysterious source of funding.For small business owners however, it represents a golden ticket—a pathway that, when navigated correctly, can propel a modest enterprise into the ranks of industry powerhouses.In this article, we embark on a comprehensive journey through the complex world of venture capital. We'll peel back the layers, delving into the intricacies that often shroud this funding source in mystery. By the time you reach the end, you'll possess a newfound understanding of venture capital, equipped with the knowledge to decipher its inner workings and strategically position your business to attract investment.So, fasten your seatbelts, as we venture into the realm of venture capital, unlocking its secrets for the benefit of small business owners seeking growth and success. In this guide, we will cover: What is venture capital? How venture capital works Types of venture capital (and capitalists) The venture capital lifestyle Advantages and disadvantages of venture capital What services can a venture capital firm offer besides investment? Conclusion: Venture Capital as an Investment Option FAQs What is venture capital?Venture capital (VC, or a ‘venture capital fund’) is an investment fund made up of contributions from wealthy individuals or companies. These venture capitalists incorporate or give their money to a VC firm to manage their investment portfolios for them. The VC firms invest in startups in exchange for equity.“By raising venture capital, young companies are able to build their businesses faster than if they used revenue or founders’ savings alone.” Tominsey explains.“In return for money, startups give investors an ownership stake in their companies. As that startup grows, so does its value and, in turn, the value of the VC investors’ ownership stake.” How venture capital worksWhen raising a fund, VC firms will often target a specific sector to invest in, and seek new emerging companies that would be considered high risk by most banks, but also potentially high reward. Inventors are highly favoured!For example, Partech Ventures raised 400m to specifically invest in innovative tech startups in 2017, before the cautious investing trend of 2023. The fund was drawn from 30 major European and US investors along with business angels, entrepreneurs and tech executives.A fund will normally finance multiple different businesses – with the number of potential individual investments announced when the fund launches.As stakeholders of the VC firm, all investors are made aware of what funds or businesses their money is being invested into, as well as the potential risks and rewards of such investments. Types of venture capital and venture capitalistsThere are a few different ways venture capitalism can take shape, and different types of people/organisations you may encounter along your journey. They include:Angel investorsAngel investors are usually one single investor seeking opportunities solo, whereas venture capitalists would typically be comprised of a group of investors from a company.Peer-to-peer lendersPeer-to-peer (P2P) lending is a loan obtained from other individuals or a group, cutting out the traditional middleman, such as a bank. Crowdfunding would fall under this category, as would loans from your family and friends.BanksBanks can be considered a kind of venture capital because they are the go-to for funding new businesses, despite it becoming slightly harder for SMEs to gain this funding in recent years. Despite the fact that they are not personally invested in what your business is necessarily and are unlikely to offer personalised support along the way, they offer starting funds to aspiring business owners that they deem to be viable enough. The venture capital lifecycleWith the help of our expert Rob Tominey here, this section will take you through the stages of venture capital and what investors will be looking for at each stage.Stage 0: Pre-seed funding“Pre-seed investments are the earliest stage of venture capital investment,” Tominey notes, “and are typically made when a company is less than two years old.”When seeking pre-seed funding, writing your business plan in the first instance is your best bet.Entrepreneurs that write early-stage business plans are more likely to succeed, especially when aiming to seek venture capital funding. The sooner you can get your plans in order, the sooner you can plan a prototype, create a minimum viable product and launch to beta testers – all crucial stages on the way to making your business seem credible and exciting to venture capitalists and their firms.Not everyone will get pre-seed funding. Angel investors and early-stage venture capital firms are the main backers at the pre-seed and seed funding stage – one that is both the most daunting for entrepreneurs and the riskiest for investors given the lack of track record of the startup involved.It is an incredibly tough prospect to sell when you don’t have much to back it up yet – but if you think this may be the case for you, don’t fret. There are other options such as grants, loans and crowdfunding to consider.In addition to this, if you create a business plan, believe it or not but you will be considered ahead of the game. According to a new survey by accountancy firm PKF, 46% of companies have a strategy but have not formally written it down, and 9% of firms have no business plan at all.What you will need:A business planTestimonials from any credible stakeholders you may have who may be able to vouch for your businessOther resources:Startup business plan essentials: preparing for change and growthStartup business plan essentials: creating vision, value and mission statementsTypes of market research to plan or launch your businessFirst 100 days: the startup checklist every new business needsSole Trader vs Limited Company or Partnership Pre-seed market research - top tip: Your market research should not involve family or friends. Aim to get a truly randomised set of respondents that will give you an accurate, unbiased reflection of your business idea.Source: How to start a business – an 11 step guide to success Stage 1: Seed fundingTominey writes: “Seed stage companies have usually developed their first product, and will have a small number of ‘early adopter’ customers or trials, although revenue is often low.”The seed funding round is all about demonstrating that your startup has a proven track record and the ability to scale quickly and provide a serious return for investors.Normally, a seed funding round will contain less than 15 investors who’ll gain convertible notes, equity, or a preferred stock option in exchange for their backing.While a business may have certain aspects unfinished or be still in the development stage when looking to raise seed capital, they will need a minimal viable product to raise seed funding – but not pre-seed funding.Advantages for startups in the seed funding range from being given more time to fine-tune their business model, more time to find experienced business partners, increased capital for future rounds, and more flexibility to pivot if any drastic changes need to be made.What you will need: A pitch deckOther resources:How to pitch to investors – beyond the pitch deck10 steps to structuring your funding pitchHow to find angel investors for your startup businessDiary of a startup: handling the MVP or market-ready product dilemmaStage 2: Early Stage funding (AKA Series A, B, C and beyond)According to Tominey:“The early stage funding/series A stage is often when you would point to a company and say it was a ‘fast growing startup’. By this point, the company has usually grown its annual revenue to a high six or seven figure number in a short period of time, and will be aiming to continue growing revenue fast over the 12-24 months post-investment.Investments at series A stage are risky but, with significant capital and a working product, investors can still expect strong capital growth if the business does well.”During early stage funding, investors are typically looking for a market-proven product that will allow you to easily multiply in revenue within 18 months.Though unusual, some startups will skip seed funding and go straight to the early stage funding or what is also known as a ‘Series A’ phase. This approach is the rare event in which a venture capital firm will approach the startup first, via an entrepreneur-in-residence. Entrepreneurs-in-residence are experts in a particular industry sector, hired by venture capital firms to perform due diligence on potential deals, and expected to develop and pitch startup ideas to their firms. However, in such an instance, the entrepreneur will be asked to give away quite a large chunk of equity – often bigger than 20%. Investors will also be more likely to back a business at this stage (even if it didn’t raise seed funding) if the entrepreneur in question has already had a successful large exit with a previous startup – or significant experience and connections within their industry.Series A, B, and COnce a business has developed a product, it will need additional capital to ramp up production and sales before it can become self-funding. The business will then need one or more funding rounds, typically denoted incrementally as Series A, Series B, and Series C.Startups which are at the Series C and beyond stages of funding have all but proven to venture capital firms that they’ll be a long-term success – with original backer’s shares now having increased considerably in value.What you will need: N/AOther resources: N/A Bridge financing: the gap between the different stages Bridge financing is when a startup seeks funding in between full VC rounds, and can be provided in between any of these funding stages. The objective is to raise a smaller amount of money to “bridge” the gap when current funds are expected to run out prior to planned future funding, intended to meet short-term working capital needs. Stage 3: ExitsAccording to Investopedia, “An exit strategy is a contingency plan executed by an investor, trader, venture capitalist, or business owner to liquidate a position in a financial asset or dispose of tangible business assets once predetermined criteria for either has been met or exceeded.”Venture capitalists exiting is not necessarily a bad thing – in some firms, it is common practice. Once you reach this stage it means that the business has earned a significant amount of money, and VC’s can now enjoy this to the fullest by selling their shares to other investors as the business reaches the public equity market through an Initial Public Offering (IPO).Tominley has some expert knowledge to share in this area:“Whilst crowdfunding has proliferated over the past decade, it does not match the diversification, due diligence and ongoing management that comes with investing in venture capital funds – and the results back this up – venture capital backed startups are four times more likely to exit than crowdfunded startups.”What you will need: N/AOther resources: N/A Initial public offering An IPO is where your business makes it to the stock exchanges. Through this process, colloquially known as ‘going public’, a privately held company is transformed into a public company. According to Glenn Solomon, partner at GGV Capital, banker's generally expect businesses who have hit the $100m (£63.86m) mark to consider going public. Advantages and disadvantages of venture capital Pros Ability to build faster than if you use revenue or founders’ savings alone. Opportunity for 'high-risk' companies to obtain funding Additional benefits such as support, guidance and mentorship No repayments Cons You will have to give away equity in your business in exchange for support What services can a venture capital firm offer besides investment?With alternative forms of raising finance such as crowdfunding and the rise of the ‘armchair investor’, businesses can nowadays rise millions of pounds worth of investment without giving away an inch of precious equity.So why do businesses decide to part with larger chunks of equity and go down the venture funding route?The reason for this often lies in the role of the venture capitalist – and what they can offer your business besides the initial injection of cash. These invaluable additional benefits can include:Support services: Increasing in popularity in recent years, many of the larger venture capital firms will have their own in-house marketing, legal, tech and recruitment teams that will offer their services to startups and smaller businesses that receive investment.Strategic introductions: Often experienced entrepreneurs themselves, investors or partners in venture capital funds should have a wealth of contacts that your business should be able to tap into. Streamlined and direct, these introductions will be highly specific, strategic and targeted. Said introductions could include potential partnerships with larger corporates, new investors or clients, or even potential hires.Experience in efficiency: A seasoned investor and businessperson can streamline communication channels and ensure boardroom meetings are suitably productive. Helping to formulate strategy and direction, an investor can ensure your business is prioritising properly – from the top down.Wider market knowledge: While you'll no doubt have spent the majority of your time concentrating solely on your own business, venture capitalists have been scanning various horizons. As a result, an engaged investor can give much-needed insight into international markets, potential new clients and even exit opportunities.Best practice: Investors can add significant value by helping instil good governance in areas such as financial controls and reporting, business ethics, and contractual issues and procedures. Conclusion: venture capital as an investment optionOverall, the process of securing venture capital, and the decision process venture capitalists use to fund a company, is somewhat elusive.One study report in the Harvard Business Review states that VCs rarely use standard financial analytics, instead preferring to reach out to their network to source potential investments – which leaves a certain element of the entire process down to chance, and luck.However, there are always ways you can increase your luck. On the side of the business owner, you can try to prepare your business to the highest standard you possibly can, try to fulfil all the requirements noted in this guide so that the entrepreneurs-in-residence will be impressed when they do their due diligence, and perhaps also increase your chances through networking and getting to know the right people.None of this is outside the realm of reality. It is in fact pretty doable if, as with anything, you’re simply willing to put the work in. Venture capital funds: A-Z Directory Looking for equity investment? Here’s our directory of VCs that invest in start-ups. Frequently Asked Questions How do venture capitalists make money? Venture capitalists invest in startups in exchange for an equity stake in the business (typically between 25% and 50%). How can I prepare my business for venture capital investment? You will need to make sure that at the bare minimum, you have a business plan and a pitch deck that showcases your business idea. A cash flow forecast, continuity plan and may also be useful to have. What factors should I consider when approaching venture capitalists? Different stages of the funding process will require you to showcase different things when approaching venture capitalists, but the most important thing is to have as much proof of viability as possible. Is Dragons Den venture capital? Yes. According to the BBC, “Dragons' Den is now an international brand with versions airing in countries across the globe. Entrepreneurs pitch for investment in the Den from our Dragons, five venture capitalists willing to invest their own money in exchange for equity.” Share this post facebook twitter linkedin Tags Essential Guides News and Features Written by: Stephanie Lennox Writer Stephanie Lennox is the resident funding & finance expert at Startups: A successful startup founder in her own right, 2x bestselling author and business strategist, she covers everything from business grants and loans to venture capital and angel investing. With over 14 years of hands-on experience in the startup industry, Stephanie is passionate about how business owners can not only survive but thrive in the face of turbulent financial times and economic crises. With a background in media, publishing, finance and sales psychology, and an education at Oxford University, Stephanie has been featured on all things 'entrepreneur' in such prominent media outlets as The Bookseller, The Guardian, TimeOut, The Southbank Centre and ITV News, as well as several other national publications.