Venture capital (VC) is a type of private equity financing provided by investors to startups and early-stage companies that exhibit high growth potential. Unlike traditional loans, venture capital investments come with significant risk, as the companies receiving funding are often in their infancy and may not yet be profitable. However, the potential rewards can be substantial, as successful ventures can generate outsized returns for investors.
Whether you’re an entrepreneur seeking funding, an investor looking to participate in the next big opportunity, or simply curious about how startups scale, this comprehensive guide will provide valuable insights into the world of venture capital.
How Does Venture Capital Work?
Venture capital (VC) is a form of private equity financing that involves investing in early-stage, high-potential, and often high-risk companies. Investors' goal is to generate substantial returns as these companies grow and succeed. Venture capital firms and individual investors, known as venture capitalists, provide the necessary financial resources, as well as strategic guidance, mentorship, and networking opportunities to help startups scale and achieve their business objectives.
Venture capital investments typically focus on innovative companies in sectors such as technology, biotechnology, clean energy, and healthcare, among others. These startups usually lack access to traditional sources of funding, such as bank loans or public markets, due to their unproven business models or the speculative nature of their industries.
Venture capital investments are made in various stages of a company's life cycle, from seed funding and early-stage financing to later-stage rounds. In exchange for their investment, venture capitalists often receive equity in the company, which can lead to significant profits if the company becomes successful and either goes public through an initial public offering (IPO) or is acquired by another business. However, venture capital investing also carries the risk of losing the entire investment if the startup fails to achieve its goals.
What Is a Venture Capital Firm?
Traditionally, entrepreneurs raised money for new businesses by borrowing from banks. This model posed some significant problems for people who were pioneering new businesses or ideas that were not yet accepted in the general business arena as “legitimate.” The reason for this is simple; traditional banks are loaning out their client’s money and as such, they prioritize security above profit potential.
That’s why home loans are known as “secured loans”; because the money the bank is lending is secured by the house. In the event of a borrower default, the bank will foreclose on the house and then sell it to recoup its losses. When it comes to a new business, little actually secures the bank’s money.
A startup doesn’t typically own the space where it operates, and it has no history of making money or any assets aside from the computers and desks in the office. That means if the loan goes south, the bank gets left holding the bag. The risk profile of funding startup businesses scares most traditional lenders.
Why Venture Capital?
A venture capital firm comes into the picture at this juncture. VC firms exist for 1 reason: to fund startups and new business ventures in exchange for equity in the startup. VC firms are usually led by experienced investors or business professionals with a history of successful endeavors. They pool contributions from other people in their network and seek out growth opportunities by investing in startups, knowing full well that only a few of them will pay off. It’s the ultimate high-risk, high-reward proposition.
If the startup is successful, the VC firm (and its investors) will have gotten equity in a hot business for pennies on the dollar in comparison to the share price at IPO or subsequent stock offerings. VC firms and venture capitalists in general focus on funding startups in the following fields:
- Technology (e.g., robotics, artificial intelligence)
- Biotech
- Clean energy
How Do Venture Capitalists Choose Investments?
Everyone has heard the saying that “beauty lies in the eyes of the beholder.” This sentiment is especially true when it comes to venture capitalists choosing investments. A lot has to do with how knowledgeable the individual venture capitalist is in the field that the startup will be entering. With that said, however, venture capitalists look for basic characteristics when assessing an investment.
The most important fundamental for a venture capitalist is risk vs. reward. Several basic tenets make up the risk vs. reward equation:
- How profitable can the business be if everything goes according to plan?
- Will this startup require substantial follow-on funding after my investment?
- What is the total addressable market for the startup?
- How likely is it that the startup will fail?
- Does the entrepreneur or startup founder have a history of success?
- How much knowledge does the venture capitalist have of the entrepreneur’s chosen field of endeavor?
- Does the venture capitalist have resources outside of sheer funding that they can bring to make the startup profitable?
When a VC firm is happy with the answers to most of these questions, it may be inclined to invest. If too many of these questions go unanswered, the firm is less likely to invest or may demand a larger equity share for its investment.
How Does a VC Firm Earn a Return on Its Investment?
Venture Capital sees a return by selling the equity stake in the company it acquired. This is called an "exit." Since startups are illiquid, meaning you can't sell after you invest, VCs have to wait until the startup conducts an IPO, is bought by a larger company, or finds a buyer on the private market before they make a profit.
However, with 80-90% of startups failing, that means those 10-20% that do see an exit need to make up for the rest. So, imagine for a moment that you are a venture capitalist who invests $5 million in a fledgling social media company in exchange for a 25% equity share. The company gets off the ground and does well enough to meet the requirements of the U.S. Securities and Exchange Commission (SEC) for an initial public offering.
After the first day of the IPO, the company sells $200 million worth of stock. That means the 25% of the company you bought for $5 million is now worth $50 million and you’ve made a $45 million profit, which could be worth even more in the future if the stock continues rising. At this point, you could also sell your shares at a healthy profit, then reinvest some, or all, of that money into new startups.
However, other methods exist to make a profit through venture capital financing (VC financing). Sometimes venture capitalists make operating loans to a startup in exchange for annual interest, which generates income for the venture capitalist who made the loan. The interest rates for VC financing can be significantly higher than the interest rates charged by banks because of the elevated risk involved with financing startups.
What Is a Venture Capital Fund?
A venture capital fund gathers contributions from investors with the intention of pooling those funds to invest seed money into various new business ventures. Typically, venture capital funds focus on offering venture capital to a specific type of startup (e.g., tech, transportation, green energy) that operates in a field where the fund’s managers have specific experience.
These funds actively seek out startups or make themselves available to entrepreneurs seeking funds with the express goal of making early investments into businesses with upside. If the startup becomes profitable, the fund usually profits from the equity it gained in exchange for providing angel money for the startup.
Who Can Invest in Venture Capital?
Investing in startups carries a lot of risk. The truth is that most new companies and startups fail, which means most venture capital investments will not return any money to their investors. Of course, when venture capital investments do pay off, the money that can be generated in 1 successful startup like Meta Platforms Inc. (NASDAQ: FB) or Amazon.com Inc. (NASDAQ: AMZN) can cancel out years of losses and make investors wealthy beyond their wildest dreams.
Due to the volatility of venture capital and the tremendous amounts of money it often demands, making venture capital investments has traditionally been limited to the wealthiest investors. However, that practice is beginning to change with the advent of startup crowdfunding, which is opening venture capital to an entirely new class of investors.
Venture Capital for Retail Investors
When venture capital investing first came into vogue, it was because venture capitalists and VC funds were making tons of money from early investments in tech startups. Retail investors quickly found out that the size of most venture capital investments combined with the high risk of loss effectively froze them out of the market.
Fortunately, there is a solution, one that was probably funded by a venture capitalist or VC fund. Startup crowdfunding platforms, which are internet-based websites that allow retail investors to put money into startups, have brought venture capital within reach of everyday investors. These platforms pool smaller individual contributions from retail investors to directly invest in startup offerings listed on the platform. Other platforms bundle investor contributions into a VC fund, which theoretically will grow money for the investors over time.
Frequently Asked Questions
Is Shark Tank a venture capital?
Do venture capitalists make money?
What is venture capital in simple words?
Venture capital is money invested in small or early-stage companies with high growth potential. Venture capitalists provide this funding in exchange for a share of ownership or equity in the business. It helps startups grow, but it’s a high-risk, high-reward investment since many startups fail, while successful ones can deliver huge returns.