What Is Venture Capital and How Does It Work?
Startup founders and other plucky entrepreneurs tend to be the face of innovation in America. This makes a good deal of sense, if by “innovation” we mean things like bold and disruptive business ideas that fuel economic growth (or create new economies altogether). But the money and support to help these ideas grow into real-world companies with real-world value—well, that’s a kind of innovation, too. And it comes, in large part, from a type of private equity called venture capital.
Venture capital (VC) provides capital to early-stage startups that have the potential to grow into much larger and more valuable companies over time. Venture capitalists may also provide other types of support to help these startups get off the ground, including advice and expertise to help refine their business concepts. In this article, we’ll further define venture capital and walk through how VC works in practice, so you can better determine if this type of private equity funding could be a part of your company’s future.
- What is venture capital?
- What is a venture capital firm?
- What is a venture capital fund?
- Venture capital vs. angel investor: What’s the difference?
- How venture capital works
- Stages of the venture capital process
- Risks for venture capital investors
- Is venture capital right for your company?
What is venture capital?
When we say that venture capital is a type of private equity, we mean that it is a way to invest private money into private companies. Because these companies are not public, they generally do not have access to all the ways public companies can raise money, such as selling shares on public capital markets.They may also be unable to access other sources of funding, such as bank loans and other debt instruments sometimes used to raise capital.
So, what is a young startup with a brilliant business plan and a pressing need for funding to do? One popular answer, especially among technology startups, is to pitch your business to a venture capitalist investor or venture capitalist firm.
Venture capital differs from other types of private equity in that it specializes in funding startups that may not have a proven track record but offer a ton of growth potential in the coming years. In return for providing capital and other types of support, venture capitalists typically receive a minority stake of ownership in the business (50% or less).
It can be helpful to think of venture capital as an investment in a young founder or team, versus an investment in a strong and proven business model. Many venture capital firms certainly think of it as such, which is why they may opt to only take a minority stake of equity when investing in a company. By allowing the founder or founding team to retain the largest equity stake, they provide an incentive for those leaders to stick around and continue growing the business.
What is a venture capital firm?
A venture capital firm (also known as a VC firm) is a private equity firm that invests in early-stage companies.
Venture capital firms generally play quite an active role in trying to increase the value of the companies they invest in. They may provide not only essential funding, but also the business resources and expertise that comes with knowing that company’s particular industry ecosystem inside and out.
This is an important point to linger on for a bit, because VC firms typically don’t just invest in any promising company. These are professional investors we’re talking about, and they tend to focus their investment portfolios on businesses and industries they know well. High-growth industries and themes that a VC firm may focus on include healthcare technology, cryptocurrency and web3, or online retail.
Of course, many of the top VC firms tend to focus on technology in some form or another, which is why VC has become nearly synonymous with Silicon Valley. Some of the bigger firms—including heavy-hitters like Andreessen Horowitz, 500 Startups, and Sequoia Capital— focus more broadly on tech and may invest in a number of different tech-related or tech-adjacent industries. There are even some corporate venture capital firms that invest in promising startups on behalf of large companies, as is the case with Alphabet’s GV (formerly Google Ventures).
But where do all these VC firms get the capital they need to pursue investment opportunities in new companies? Corporate venture capital firms like GV tend to use corporate funds for their investments, but not every VC firm has that kind of access to corporate money. Instead, many VC firms draw their money from a pool of capital that’s known as a venture capital fund.
What is a venture capital fund?
A venture capital fund (also known as a VC fund or venture fund) is a pool of money that a venture capital firm or investor raises to invest in a portfolio of early-stage companies. This money typically comes from a group of limited partners (LPs), i.e. investors with limited liability.
These limited partners may include a mix of institutional investors, large pension funds, and accredited individual investors. Collectively, the investors in a limited partnership own the majority of shares and have limited liability.
The VC firm (acting as the general partner) owns a comparatively tiny stake and takes on full liability. The firm also does all the legwork involved in managing the fund’s portfolio, from listening to companies’ investment pitches to, ultimately, selecting the companies they deem promising and working to grow the collective value of those companies.
If this sounds like a bum deal for the VC firm, think again. The firm stands to make a lot of money from this arrangement, as it collects fees for both the management as well as the performance of the fund’s portfolio. Here’s how a typical fee structure breaks down:
- Management fees from limited partners (around 2% of assets under management). A VC firm collects management fees from investors for the work they do in managing the investment portfolio. This fee may vary between firms, but it’s usually about 2% and is collected regardless of fund performance.
- Performance fees from profitable investments (around 20% of total profits). The VC firm also collects a portion of any profit it generates from its investments—typically around 20%. Investment in a successful early-stage startup can lead to huge profits in the event of a future investment round or exit, so performance fees are a good incentive for fund managers to bet on the right horses.
Venture capital vs. angel investor: what’s the difference?
You may have heard of “angel investors” — a mythical coterie of heavenly beings who rain cash down upon the heads of startup founders they deem worthy. While we hate to disabuse such a pleasant fantasy, that’s not exactly what an angel investor is.
Angel investors are typically high-net-worth individuals (i.e. very wealthy individuals) who invest their own money into early-stage companies. Angel investing can be looked at as a type of venture capital, in the sense that it serves a generally similar purpose. But angel investing differs from venture capital in several key ways.
For one, angel investors tend to put up their own money, versus raising a pool of money from limited partners. Secondly, an angel investor may have different reasons for their investment than a venture capitalist, and may (or may not) be able to provide the same level of industry knowledge and guidance.
There’s also the matter of when angel investors tend to come into the picture. In many cases, angel investors enter in first, providing early seed money to new businesses. They may later be followed by a venture capital investment, so by no means should these types of investments be looked at as mutually exclusive.
How venture capital works
In a typical VC setup, the venture capital firm manages the process and brings all the various parties together. Aside from the VC firm itself, the parties involved in a typical venture capital investment include:
- The founder or founding team. This group of entrepreneurs wants funding for their company, so they meet with the venture capital firm to present their business plan.
- The private investors. This is the group of “limited partners” mentioned above, and it may include a mix of different investors who have invested their money in the VC fund.
- Investment banks. An investment is no good if it does not come with the potential for profit, so investment bankers evaluate exit options for the VC firm. Exit options may include an initial public offering (IPO), a sale via mergers and acquisition, or some other type of liquidity event.
One of the main responsibilities of the VC firm is performing due diligence on its portfolio companies. A venture capital firm spends considerable time and energy evaluating companies’ business models, market potential, and management team in order to make more informed decisions. Many VC firms have entire teams of people dedicated to this type of due diligence work, and it’s one reason why some firms tend to only focus on one industry ecosystem or subset.
Stages of venture capital funding
A typical company is a growing, shifting thing, which means that its funding may take place in successive rounds that coincide with its growing valuation and maturity as a business. Venture capital funding tends to take place earlier on in a company’s lifecycle, but it may be involved all the way up to an IPO.
Here’s a quick and general breakdown of the stages of venture capital funding:
Pre-seed or seed round
Angel investors and venture capitalists tend to be more involved in seed-stage financing, though angel investors precede VC firms in many cases. At this stage, venture capital is really betting on the promise of a founder’s business idea and the plan they’ve put together to bring that idea to life.
Check out Pulley’s guide to seed rounds for more on how financing works, how to determine how much to raise, and how to determine your company’s worth.
Series A–C funding for developing businesses
The next stage of venture financing is likely a Series A, then a Series B and Series C. A company can continue to raise funding until it becomes profitable and gets acquired or goes through an IPO. These different stages coincide with the growth of a company in terms of its scale and production.
Late-stage funding rounds and eventual exit
A company may go through additional funding rounds beyond Series A–C, and some companies do issue Series D and E funding rounds before going public. At this stage, an early VC investor may work with an investment banker on an exit plan to secure a profit on their initial investment.
Risks for venture capital investors
Investing in unproven companies can be a high-risk business, so venture capitalists oftentimes cast their nets far and wide, with the idea that one successful investment can generate high returns that make up for a number of misses.
The potential for massive returns on a single investment is a major draw for venture capitalists. In any case, there’s no denying the strong recent performance of venture capital relative to other private asset classes; according to a 2021 data report from consultancy firm McKinsey, VC outperformed other private equity sub-strategies like buyouts from 2007–2017.
Is venture capital right for your company?
Venture capital financing is one of the linchpins of American entrepreneurship. It plays a large role in the imagination of first-time founders, and for good reason—VC has fueled the ultimate success of one-time startup companies such as Apple, Facebook, Google, Shopify, and countless others.
With that said, investors are often wrong, and there can be some disadvantages to over-relying on funding (for example: more dilution). As a founder, remember that your ultimate goal is building a successful business and not achieving a fundraising target.
If you’re interested in learning more about fundraising and how to avoid costly mistakes along the way, set up a call with Pulley today.