While venture capital is most often associated with startups and entrepreneurs in the tech or other high-growth industries, small business owners may also be able to tap into this funding resource. Venture capital (VC) firms seek out high-growth businesses that can promise a high rate of return on their investment.
Let’s examine a venture capital definition, how venture capital works for small businesses, how to ask for venture funds, the pros and cons of venture capital, and alternatives for financing a small business.
How Does Venture Capital Work for Small Business?
Venture capital funds work the same for any business, no matter the size. The ideal candidate for VC financing is a business that might be bought by a different corporation in the future or will go public with an initial public offering (IPO), which are most often startup companies.
The important thing to note is that venture capitalists are looking for a high rate of return. According to the National Bureau of Economic Research, the most likely return is 25%, but can be significantly higher.
The investment can come from an individual or angel investor, a venture capital firm (where lots of investors pool their money, called private equity), or a financial institution.
Although VC firms typically look for early-stage or new businesses, some companies seek out venture capital in later stages. Seed capital is for business ideas, while startup financing funds new businesses with one full-time management member working on it. Then it goes into first-stage, second-stage, and mezzanine (or bridge) financing for growing businesses.
We walk through the steps to obtaining VC funding a little later in the article.
Can You Get Venture Capital as an LLC?
Most venture-funded businesses are C-corporations rather than LLCs — but LLCs can get venture capital funding. Businesses are encouraged by investors to turn into corporations for two reasons: If you plan to sell shares, your business must have a corporate structure; and LLCs can generate income called unrelated business taxable income (UBTI) that can become problematic for investors attempting to keep a tax-exempt status.
However, Inc. recommends remaining an LLC to avoid corporate tax once the business is sold, which can be up to 30%. According to Inc., very few startups end up going public. If they do go that route, they can convert to a corporation at any time if they need to, so it’s not necessary to start as a corporation. Also, LLCs can avoid UBTI by setting up what’s called an intermediate blocker company that acts as a middleman.
Inc. says it was able to remain an LLC while getting venture capital investments, even though there was pressure to become a corporation. Remaining an LLC might make it more difficult to secure venture capital, however.
According to Crunchbase, because of the rush to digital after the pandemic, small businesses have a much greater opportunity for high-speed growth and entrepreneurship. The market hasn’t quite caught up to the need yet, so it’s still much more difficult for a small business to get venture capital, but that doesn’t mean it’s not possible.
For example, the State Small Business Credit Initiative (SSBCI) is open to small and underserved businesses and allows for debt or equity investments. The National Venture Capital Association has a useful list of resources on the initiative.
How Much Money Do You Need for Venture Capital?
The amount of money you borrow from a venture capitalist depends on how much business financing you need. Venture capital financing usually funds startup costs to get an idea off the ground, but it can also be used to increase business cash flow after you get running. It’s a good idea to borrow only what you actually need, even if you’re offered a higher amount. The more you borrow, the bigger stake in your company you’re likely to have to give up. Also, the amount of money you’re able to secure will hinge on your business’s valuation.
As a Small Business, How Do I Ask for Funding With Venture Capital?
If you have a business or new product with a high growth potential and may offer private investors a high return, you might be ready to apply for venture capital.
The process follows these basic steps:
- While it’s possible to send a proposal to a venture capital firm cold, it’s best if the business owner is introduced to the venture capitalist by a known party. You can speak with a financial professional you work with (a banker, certified public accountant, lawyer, etc.) to see if they can make a referral.
- The appropriate party in the VC firm will then set up a phone call with the business owner if they’re interested.
- The business owner will provide a presentation or pitch deck of the product or business plan. If the presentation goes smoothly, the venture capitalist meets with the business owner to ask questions.
- The venture capitalist sends a term sheet to the business owner. The term sheet outlines the terms of the potential funding — but it’s not an offer just yet.
- The due diligence process is started by the VC firm. During this process, the investor will conduct a thorough investigation of your business to determine if there’s a high likelihood that it will be profitable.
- Once due diligence is completed, the VC firm will send the business owner what is called offering documents. These documents clarify the terms of the funding, such as the total amount and the percentage of equity the venture capitalist receives in return.
- The business owner decides whether or not to accept the offer. If accepted, the business owner gets the funds in their bank account.
Advantages of Venture Capital
Here are some of the advantages of using venture capital for your business.
- Don’t pay interest, so you won’t have to search for low interest rates
- May receive a partnership, guidance, and a boost to your business network
- Can get a large amount of funding
Disadvantages of Venture Capital
Now let’s look at some of the disadvantages of using venture capital for your business.
- You have to give up partial or majority ownership in your company
- It can be a big challenge to get small business funding from private equity firms
- The process can be long and complicated
Alternatives to Venture Capital
If you can’t qualify for venture capital or prefer to go with more traditional funding, there are many options for your small business. The most frequently used are:
- Equity crowdfunding: This is another way to raise venture capital. Platforms like EquityNet and Fundable allow entrepreneurs to raise capital in exchange for a fee.
- Traditional bank loans: Lenders give term loans as a lump sum of money, and you pay interest on what you borrow. The Small Business Administration (SBA) partners with financial institutions to offer government-backed loans, but they are challenging to qualify for.
- Alternative loans: Online small business loans offer easier applications than bank loans and faster funding times.
- Business lines of credit: Borrowers can access a pool of money as needed — up to their credit limit — and only pay interest on what they borrow.
- Business credit cards: While you may not be able to pay for all of your startup costs using business credit cards, they are an essential tool to increasing access to flexible capital.
- Merchant cash advance: Offers quick access to financing if your credit score is not great, but you’ll likely pay higher interest rates.
The Bottom Line on Small Business Venture Capital
If your small business is looking for financing, going the venture capital route will be a challenge — but not impossible. If you have the right amount of growth potential, you may be able to secure venture capital. If not, debt financing may be open to you.
It’s essential to make sure your business’s finances are in good shape by getting your cash flow under control and your business credit in order. (Learn how to establish business credit in this Nav guide). There are many financing options that may be available to your small business, and work with Nav to find the right one for your business.
This article was originally written on May 10, 2023.