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Here's some useful advice from Dan Lok on how to make smart decisions when thinking about investing in a venture capitalist.

Dan Lok shares the decision process of a venture capitalist

Many startup companies are interested in receiving venture capital funding. Most startups do not have a great deal of cash on hand when they begin their journey, and the money comes in handy when developing ideas and products as well as hiring early staff.

Entrepreneurs often wonder about the decision processes shared by venture capitalists. Their method of choosing which companies are funded and which companies are not can seem capricious. Venture capitalists are very careful with their money, and they don’t make hasty decisions.

Dan Lok, an entrepreneurial expert, goes over the thought process of a venture capitalist and explains how your startup can catch their eye.

What is a Venture Capitalist?

A venture capital firm is a private equity investor. These firms provide capital to companies that exhibit a high potential for growth in exchange for a controlling equity stake. Venture capital firms fund startup ventures, but it can be difficult to attract their attention unless you have the right connections.

Venture capitalists enter into these deals because they stand to make a huge return on their investment if the company is a success. Unfortunately for venture capital firms, they experience high failure rates due to the instability of unproven companies.

Learning More about Venture Capitalists

A venture capital firm is usually set up as a limited partnership. Together, the partners invest in the VC fund. When making decisions, the fund committee gets together and talks about the merits of each emerging company. The investors pool their capital and deploy it to fund firms in exchange for a large equity stake.

Venture capital firms do not come in at the very beginning of a company’s life cycle. Instead, they focus their energies on companies that are looking to commercialize their ideas. VC funds buy a stake in these companies, support their ongoing growth, and anticipate cash out with a high return on their investment.

Deal Sourcing

According to Harvard Law School, venture capital or VC firms screen an average of 200 companies per year and only fund 4. Most of the venture capital companies’ deal flow comes from their network of connections. Only 10 percent of referrals to VC firms are generated by the startups themselves.

In order to attract attention to your company, you will need to make sure that you have a wide professional network. Your company will need to be in the public eye, and you will need to somehow build a relationship with the VC firm.

Selecting Investments

Venture capital firms place the most importance on the quality of the managing and founding teams. In addition to the quality of management, business-related factors are important. These include the business model, the product itself, the company’s position in the market, and the outlook for the industry. The company valuation is also part of the decision-making process, but it is more important in later-stage deals.

Venture capital firms don’t work with hunches when they are selecting companies in which to invest. They have carefully selected algorithms and mathematical formulas that show which companies are most likely to make a return on their investment.

The most commonly used metric is cash on cash return. This metric measures the annual return the investor makes on the company in relation to the amount invested.

Another commonly used metric is the internal rate of return or IRR. IRR is the annual rate of growth that an investment is expected to generate.

Writing Contracts and Structuring Investments

Venture capital contracts are set up so that the venture capital firm does well when the company does well. Investors need to be able to take control if the entrepreneur cannot perform.

Venture capital firms are typically inflexible on investment rights, valuation, and board control, along with other stipulations.

Tips on Getting Venture Capital Funding

With these stringent requirements in place, it may be discouraging for startup companies who want VC funding. There are concrete steps your company can take to attract venture capital attention and to secure a deal.

1. Be Realistic

Venture capital is often restricted to tech companies. 36 percent of venture capital funding goes to software firms. Another 17 percent goes to biotech firms. Only 10 percent goes to media and entertainment companies. If your company does not fall into one of these categories, you may not have a realistic chance of getting VC funding.

2. Have a Polished Business Plan

Your quest for VC funding will be fruitless unless you have a complete and polished business plan. You will need an elevator pitch, a pitch deck, and deeply detailed financial projections.

At a minimum, you will need a minimum viable product (MVP), an established customer base, and a solid team of founders and managers.

3. Be Clear on Ownership

You will need to be able to give a detailed outline of exactly who owns your company. You will need to know all of your shareholders and the rights they hold. Investors need to know this because they will want to find out whether their investment is diluted.

4. Choose Carefully

Venture capital firms vary a great deal. Some firms can only offer a few hundred thousand dollars while others can manage millions. Some VC firms specialize in small companies, while others prefer large enterprises.

Finding Success in the Venture Capital Arena

Dan Lok understands that the process of getting venture capital funding is daunting. When you go in with a solid concept of what you’re looking for, you will be more likely to succeed. Remember to be realistic about your chances, and don’t plan on getting VC funding if you are not in a preferred industry.

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