Venture capital (VC) is one of the most common terms used for any kind of high-risk, equity financing offered to emerging ventures. The term has been applied to angel capital, crowd capital, alliance capital, small-fund VC, and top-tier VC. While the different types of equity can all be termed as “venture capital,” and many angels do call themselves VCs, it would be useful to really understand the different types of venture capital, why and when entrepreneurs need “real” venture capital, and when they can succeed with the other types of VC.
Angel capital (AC), from small investors, crowd-financiers, friends, and family is limited capital to spur growth. It is usually capital from individuals who can invest smaller amounts of money. These small investors have limited negotiating clout and usually do not demand board seats, control, or exit rights, i.e. rights to sell the company or its shares in a strategic sale or in an initial public offering (IPO). Mostly they hope that the venture is sold or taken public.
“Real” venture capital (VC) is “unlimited” capital from institutional funds many of which are organized as limited partnerships. This type of fund can invest massive amounts of money. Even among VC funds, there is a hierarchy. The top 20 VCs, nearly all of whom are in Silicon Valley, are said to earn 95% of VC profits, which signifies that the rest are earning meager profits or failing. Lately, a new breed of super VC fund, such as the one organized by Masayoshi Son of Softbank, has been changing the VC landscape by offering amounts larger than the size of many VC funds – such as the $7 billion invested in Uber.
There are two major reasons why entrepreneurs need AC and/or VC.
#1. To Spur Growth: Ventures need financing to grow sales, to fund losses and to finance the increase in assets. Some strategies used by unicorn-entrepreneurs to reduce VC needs include:
- Controlling the growth rate to grow with limited capital
- Bootstrapping to reduce losses, and funding growth from debt and internal cash flow, till Aha
- Raising prices to control the growth rate and generate higher cash flow; and increasing the growth rate after Aha when capital is easier to obtain
- Designing the business strategy to initially focus on market segments that can pay more
- Outsourcing, leasing fixed assets, and selling direct to consumers who pre-pay.
To Dominate: Ventures often need capital is to dominate an emerging industry or trend where there are many ventures competing for the privilege and where the ventures have little differentiation. In such cases, the size of the war chest may be the principal weapon. Contrary to common assumptions, most unicorn-entrepreneurs dominated by delaying VC or avoiding it altogether. They used skills and smart strategies. Bloomberg beat a much-bigger competitor by developing a better technology, getting a strong lead, and using alliance capital. Michael Dell was able to beat VC-funded ventures by selling direct-to-consumer and financing with customer and vendor capital.
So why does this matter beyond the question of definitions?
Firstly, ventures with limited capital that are competing against ventures with unlimited VC may have to either seek unlimited VC themselves, seek success in a niche market, become better leaders, or fail. eBay was doing very well and growing without VC. But it attracted better funded competitors that imitated eBay’s growth strategy. This forced eBay to get “unlimited” VC from one of the top 20 VC funds in order to dominate its industry.
Secondly, VCs invest after the venture shows evidence of potential, i.e. after Aha. This means that all ventures will need AC and capital efficiency till their potential is evident.
Thirdly, about 90% of ventures do not get AC and approximately 95% of those who get AC do not get VC. So they will have to be finance-smart if they want to succeed.
This means that 100% of entrepreneurs will need to be finance-smart till Aha. 99.9% will need to be finance-smart because they will never get VC. And 80% of those who get VC will wish they had been finance-smart and avoided VC because they will fail with VC. Those who get VC and succeed will wish they had been finance-smart to delay VC that would have allowed them to retain control of the venture and keep more of the wealth created.
MY TAKE: Entrepreneurs can benefit by knowing the real reason they are seeking VC, and the nature of their competitors. If they are competing against a Top-20-VC-funded venture, or a corporation with deep pockets, they may want to find similar capital, or focus on a niche market, or develop a better strategy and win with skills. This is what entrepreneurs such as Walton, Dell, and Gates did.