How Venture Capital Works
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America is known for its entrepreneurial spirit and leadership in innovation, but transforming a fresh new business concept into a viable business isn’t easy. Many startups rely on venture capital to help provide both funding and expertise, with the hope of generating handsome financial returns if and when the business takes off.
Let’s dive into the world of venture capital and how it works.
What is venture capital?
Venture capital is a type of private equity investing where investors fund startups in exchange for an ownership stake in the business and future growth potential.
Angel investors often kick-start early-stage startups before venture capitalists get involved.
After the company begins to bring in revenue and requires additional investment, venture capitalists enter the scene to help the company expand even further. As revenue grows stronger and profit margins widen, venture capitalists typically exit and give way to private equity investors.
Venture capital is an important financing vehicle for startup businesses. New, unproven business concepts usually can’t access traditional funding sources, which often require evidence of business profitability, a track record, collateral and credit scores — qualifications that fledgling enterprises usually don’t have until later.
How venture capital works
The venture capital process involves several parties:
Entrepreneurs: Founders or owners of the business in need of capital and expertise to advance their business concept.
Limited partners: Private investors (usually institutions such as pension funds, foundations and endowments, family offices and high net worth investors) willing to invest in higher-risk startups in an effort to capture outsized returns and diversify their investment portfolio.
Venture capitalists or VC firms: An individual or firm that provides resources (capital, know-how, networking) for aspiring startup companies and raises funding by offering investment opportunities to limited partners.
Investment bankers: Deal-makers who look for companies to sell via mergers and acquisitions or other types of capital raising, such as initial public offerings.
VC firms connect all the parties together. They spend time vetting entrepreneurs and startup companies to seek out promising deals. Then, these deals are packaged into a venture capital fund, which VC firms market to limited partners to raise capital commitments. VC firms supply funding and guidance to entrepreneurs to help their businesses succeed. They also stay in touch with investment bankers to assess potential exit options.
Stages of venture capital
During the venture capital process, many startups navigate through multiple stages or rounds of financing, including:
Seed: During this very early stage of development, entrepreneurs flesh out their business plan and often use seed capital for research and development to determine their product offering, target market and business strategy. Angel investors tend to be more involved here.
Early: As the business moves to scale production, operations and marketing, it can raise its first round of funding, called Series A. As the business grows and expands, successive rounds (Series B, C) may follow.
Late: When the business prepares for M&A or an IPO, it may issue additional funding rounds (Series D, E) to create the ideal market conditions for VC investors to exit the startup.
While VC firms compete to gain access to the best deals, they also support one another by investing together. Typically, several VC firms participate in each round of investment, with one firm serving as the lead investor and the others as secondary investors. This helps to enhance the credibility of the startup business and also spreads work and risk across various firms.
How to invest in venture capital
Typically, the limited partners of VC firms are institutional investors such as foundations and endowments, insurance companies and pension funds or family offices. However, high net worth individuals who are accredited investors — meaning your net worth alone or with a spouse surpasses $1 million, or your earned income exceeds $200,000 for the past two years ($300,000 with a spouse) — can also participate in venture capital funds and direct investments.
The minimum investment and qualifications required differ with each venture capital fund offering. You can check with your brokerage firm or financial advisor to see what venture capital options are available on their platform.
With the popularity of venture capital investing, other avenues such as crowdfunding platforms have opened up that allow both accredited and nonaccredited investors to gain access to venture capital funds and investments.
Why invest in venture capital
According to Pitchbook.com, $156.2 billion was invested into U.S. startups in 2020, a 13% increase from 2019. There are many reasons why investors are attracted to the venture capital industry.
As with many investments, the higher the risk, the higher the reward. This rings true when it comes to venture capital. Although many VC-backed companies fail, finding a "unicorn" — a private startup company valued at $1 billion or more — within your portfolio can more than make up for the others.
The earlier the stage of investment, the higher the risk and return. The Corporate Finance Institute, an online financial education and certification provider, reports that successful seed investments can return 100 times or more while later-stage VC investments generally return about 10 times.
In addition to the potential financial reward, investing in private companies augments portfolio diversification by including an asset class that has a different risk-return profile from traditional stocks and bonds.
Many investors also enjoy the excitement that comes with being involved in an early-stage startup: Often these companies are working to disrupt a particular industry and provide innovative products and services — and playing a part in that evolution can be appealing.
Risks to keep in mind
There are risks to consider when investing in venture capital.
Illiquidity: When committing funds to venture capital, you are generally locked into a long-term, illiquid investment. Since many startups take five to 10 years to mature, venture capital funds often operate on a 10-year time frame. That means profits may not be distributed back to investors until 10 years after the fund closes and stops taking in new capital commitments.
Transparency: Public companies are continually followed and evaluated by research analysts; private companies aren't. In addition, startups with new business concepts probably won’t have any comparable companies, which are often used to benchmark a company’s value. These factors make it hard to know if what you’re investing in is worthwhile.
Cost: Getting involved in venture capital can be costly compared with traditional investments. Typically, venture capital firms charge a management fee of about 2% of assets under management along with additional performance fees (or "carry") of about 20%. This carry means the VC firm collects a 20% share of the profits generated by its investment funds.
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