Venture Capital: What Is VC and How Does It Work?

What you need to know to unlock long-term growth potential

Venture Capital

Investopedia / Michela Buttignol

What Is Venture Capital (VC)?

Venture capital (VC) is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks, and any other financial institutions.

However, it does not always take a monetary form; it can also be provided in the form of technical or managerial expertise. Venture capital is typically allocated to small companies with exceptional growth potential, or to companies that have grown quickly and appear poised to continue to expand.

Though it can be risky for investors who put up funds, the potential for above-average returns is an attractive payoff. For new companies or ventures that have a limited operating history (under two years), venture capital is increasingly becoming a popular—even essential—source for raising money, especially if they lack access to capital markets, bank loans, or other debt instruments. The main downside is that the investors usually get equity in the company, and, thus, a say in company decisions.

Key Takeaways

  • Venture capital financing is funding provided to companies and entrepreneurs. It can be provided at different stages of their evolution, although it often involves early and seed round funding.
  • Venture capital funds manage pooled investments in high-growth opportunities in startups and other early-stage firms and are typically only open to accredited investors.
  • Venture capital has evolved from a niche activity at the end of the Second World War into a sophisticated industry with multiple players that play an important role in spurring innovation.

Venture Capital

Understanding Venture Capital

In a venture capital deal, large ownership chunks of a company are created and sold to a few investors through independent limited partnerships that are established by venture capital firms. Sometimes these partnerships consist of a pool of several similar enterprises.

One important difference between venture capital and other private equity deals, however, is that venture capital tends to focus on emerging companies seeking substantial funds for the first time, while private equity tends to fund larger, more established companies that are seeking an equity infusion or a chance for company founders to transfer some of their ownership stakes.

History of Venture Capital

Venture capital is a subset of private equity (PE). While the roots of PE can be traced back to the 19th century, venture capital only developed as an industry after the Second World War.

Harvard Business School professor Georges Doriot is generally considered the "Father of Venture Capital." He started the American Research and Development Corporation (ARD) in 1946 and raised a $3.5 million fund to invest in companies that commercialized technologies developed during WWII. ARDC's first investment was in a company that had ambitions to use x-ray technology for cancer treatment. The $200,000 that Doriot invested turned into $1.8 million when the company went public in 1955.

Hit From the 2008 Financial Crisis

The 2008 financial crisis was a hit to the venture capital industry because institutional investors, who had become an important source of funds, tightened their purse strings. The emergence of unicorns, or startups that are valued at more than a billion dollars, has attracted a diverse set of players to the industry. Sovereign funds and notable private equity firms have joined the hordes of investors seeking return multiples in a low-interest-rate environment and participated in large ticket deals. Their entry has resulted in changes to the venture capital ecosystem.

Westward Expansion

Although it was mainly funded by banks located in the Northeast, venture capital became concentrated on the West Coast after the growth of the tech ecosystem. Fairchild Semiconductor, which was started by eight engineers (the "traitorous eight") from William Shockley's Semiconductor Laboratory, is generally considered the first technology company to receive VC funding. It was funded by east coast industrialist Sherman Fairchild of Fairchild Camera & Instrument Corp.

Arthur Rock, an investment banker at Hayden, Stone & Co. in New York City, helped facilitate that deal and subsequently started one of the first VC firms in Silicon Valley. Davis & Rock funded some of the most influential technology companies, including Intel and Apple. By 1992, 48% of all investment dollars went into West Coast companies; Northeast Coast industries accounted for just 20%.

According to Pitchbook and National Venture Capital Association (NVCA), the situation has not changed much. During the fourth quarter of 2021, West Coast companies accounted for more than one-third of all deals (but more than 60% of deal value) while the Mid-Atlantic region saw just around one-fifth of all deals (and approximately 20% of all deal value).

In the fourth quarter of 2021, though, much of the action shifted to the Midwest: The value of deals rose 265% in Denver and 331% in Chicago. While the number of West Coast deals is waning, the San Francisco Bay Area still dominates the VC world with 630 deals worth $25 billion.

$330 billion

American VC-backed companies raised nearly $330 billion in 2021–roughly double the previous record of $166.6 billion set in 2020.

Help From Regulations

A series of regulatory innovations further helped popularize venture capital as a funding avenue.

  • The first one was a change in the Small Business Investment Act (SBIC) in 1958. It boosted the venture capital industry by providing tax breaks to investors. In 1978, the Revenue Act was amended to reduce the capital gains tax from 49% to 28%.
  • Then, in 1979, a change in the Employee Retirement Income Security Act (ERISA) allowed pension funds to invest up to 10% of their assets in small or new businesses. This move led to a flood of investments from rich pension funds.
  • The capital gains tax was further reduced to 20% in 1981.

These three developments catalyzed growth in venture capital and the 1980s turned into a boom period for venture capital, with funding levels reaching $4.9 billion in 1987. The dot-com boom also brought the industry into sharp focus as venture capitalists chased quick returns from highly-valued Internet companies. According to some estimates, funding levels during that period went as high as $30 billion. But the promised returns did not materialize as several publicly-listed Internet companies with high valuations crashed and burned their way to bankruptcy.

Advantages and Disadvantages of Venture Capital

Venture capital provides funding to new businesses that do not have access to stock markets and do not have enough cash flow to take debts. This arrangement can be mutually beneficial: businesses get the capital they need to bootstrap their operations, and investors gain equity in promising companies.

There are also other benefits to a VC investment. In addition to investment capital, VCs often provide mentoring services to help new companies establish themselves, and provide networking services to help them find talent and advisors. A strong VC backing can be leveraged into further investments.

On the other hand, a business that accepts VC support can lose creative control control over its future direction. VC investors are likely to demand a large share of company equity, and they may start making demands of the company's management as well. Many VCs are only seeking to make a fast, high-return payoff and may pressure the company for a quick exit.

Pros & Cons of Venture Capital

  • Provides early-stage companies with the capital needed to bootstrap operations.

  • Unlike bank loans, companies do not need cash flow or assets to secure VC funding.

  • VCs can also provide mentoring and networking services to help a new company secure talent and growth.

  • VCs tend to demand a large share of company equity.

  • Companies that accept VC investments may find themselves losing creative control as their investors demand immediate returns.

  • VCs may also pressure a company to exit their investment rather than pursue long-term growth.

Types of Venture Capital

Venture capital can be broadly divided according to the growth stage of the company receiving the investment. Generally speaking, the younger a company is, the greater the risk for investors.

The stages of VC investment are:

  • Pre-Seed: This is the earliest stage of business development when the founders try to turn an idea into a concrete business plan. They may enroll in a business accelerator to secure early funding and mentorship.
  • Seed Funding: This is the point where a new business seeks to launch its first product. Since there are no revenue streams yet, the company will need VCs to fund all of its operations.
  • Early-Stage funding: Once a business has developed a product, it will need additional capital to ramp up production and sales before it can become self-funding. The business will then need one or more funding rounds, typically denoted incrementally as Series A, Series B, etc.

Venture Capital vs. Angel Investors

For small businesses, or for up-and-coming businesses in emerging industries, venture capital is generally provided by high net worth individuals (HNWIs)—also often known as "angel investors"—and venture capital firms. The National Venture Capital Association (NVCA) is an organization composed of hundreds of venture capital firms that offer to fund innovative enterprises.

Angel investors are typically a diverse group of individuals who have amassed their wealth through a variety of sources. However, they tend to be entrepreneurs themselves, or executives recently retired from the business empires they've built.

Self-made investors providing venture capital typically share several key characteristics. The majority look to invest in well-managed companies, that have a fully-developed business plan and are poised for substantial growth. These investors are also likely to offer to fund ventures that are involved in the same or similar industries or business sectors with which they are familiar. If they haven't worked in that field, they might have had academic training in it. Another common occurrence among angel investors is co-investing, in which one angel investor funds a venture alongside a trusted friend or associate, often another angel investor.

The Venture Capital Process

The first step for any business looking for venture capital is to submit a business plan, either to a venture capital firm or to an angel investor. If interested in the proposal, the firm or the investor must then perform due diligence, which includes a thorough investigation of the company's business model, products, management, and operating history, among other things.

Since venture capital tends to invest larger dollar amounts in fewer companies, this background research is very important. Many venture capital professionals have had prior investment experience, often as equity research analysts; others have a Master in Business Administration (MBA) degree. Venture capital professionals also tend to concentrate on a particular industry. A venture capitalist that specializes in healthcare, for example, may have had prior experience as a healthcare industry analyst.

Once due diligence has been completed, the firm or the investor will pledge an investment of capital in exchange for equity in the company. These funds may be provided all at once, but more typically the capital is provided in rounds. The firm or investor then takes an active role in the funded company, advising and monitoring its progress before releasing additional funds.

The investor exits the company after a period of time, typically four to six years after the initial investment, by initiating a merger, acquisition, or initial public offering (IPO).

A Day in the VC Life

Like most professionals in the financial industry, the venture capitalist tends to start his or her day with a copy of The Wall Street Journal, the Financial Times, and other respected business publications. Venture capitalists that specialize in an industry tend to also subscribe to the trade journals and papers that are specific to that industry. All of this information is often digested each day along with breakfast.

For the venture capital professional, most of the rest of the day is filled with meetings. These meetings have a wide variety of participants, including other partners and/or members of his or her venture capital firm, executives in an existing portfolio company, contacts within the field of specialty, and budding entrepreneurs seeking venture capital.

At an early morning meeting, for example, there may be a firm-wide discussion of potential portfolio investments. The due diligence team will present the pros and cons of investing in the company. An "around the table" vote may be scheduled for the next day as to whether or not to add the company to the portfolio.

An afternoon meeting may be held with a current portfolio company. These visits are maintained regularly in order to determine how smoothly the company is running and whether the investment made by the venture capital firm is being utilized wisely. The venture capitalist is responsible for taking evaluative notes during and after the meeting and circulating the conclusions among the rest of the firm.

After spending much of the afternoon writing up that report and reviewing other market news, there may be an early dinner meeting with a group of budding entrepreneurs who are seeking funding for their venture. The venture capital professional gets a sense of what type of potential the emerging company has, and determines whether further meetings with the venture capital firm are warranted.

After that dinner meeting, when the venture capitalist finally heads home for the night, they may take along the due diligence report on the company that will be voted on the next day, taking one more chance to review all the essential facts and figures before the morning meeting.

Trends in Venture Capital

The first venture capital funding was an attempt to kickstart an industry. To that end, Georges Doriot adhered to a philosophy of actively participating in the startup's progress. He provided funding, counsel, and connections to entrepreneurs.

An amendment to the SBIC Act in 1958 led to the entry of more novice investing in small businesses and startups. The increase in funding levels for the industry was accompanied by a corresponding increase in the number of failed small businesses. Over time, VC industry participants have coalesced around Doriot's original philosophy of providing counsel and support to entrepreneurs building businesses.

Growth of Silicon Valley

Due to the industry's proximity to Silicon Valley, the overwhelming majority of deals financed by venture capitalists are in the technology industry—the internet, healthcare, computer hardware and services, and mobile and telecommunications. But other industries have also benefited from VC funding. Notable examples are Staples and Starbucks, which both received venture money.

Venture capital is also no longer the preserve of elite firms. Institutional investors and established companies have also entered the fray. For example, tech behemoths Google and Intel have separate venture funds to invest in emerging technology. In 2019, Starbucks also announced a $100 million venture fund to invest in food startups.

With an increase in average deal sizes and the presence of more institutional players in the mix, venture capital has matured over time. The industry now comprises an assortment of players and investor types who invest in different stages of a startup's evolution, depending on their appetite for risk.

Latest Trends

Data from the NVCA and PitchBook indicate that venture-backed companies have attracted a record $330 billion in 2021, compared to the total of $166 billion seen in 2020—which was already a record. Large and late-stage investments remain the main drivers behind the strong performance: Mega-deals of $100 million or more have already hit a new high-water mark.

Another noteworthy trend is the increasing number of deals with non-traditional VC investors, such as mutual funds, hedge funds, corporate investors, and crossover investors. Meanwhile, the share of angel investors has gotten more robust, hitting record highs, as well.

Late-stage financing has become more popular because institutional investors prefer to invest in less-risky ventures (as opposed to early-stage companies where the risk of failure is high).

But the increase in funding does not translate into a bigger ecosystem as deal count or the number of deals financed by VC money. NVCA projects the number of deals in 2022 to be 8,406—compared to 12,362 in 2020.

Why Is Venture Capital Important?

Innovation and entrepreneurship are the kernels of a capitalist economy. New businesses, however, are often highly-risky and cost-intensive ventures. As a result, external capital is often sought to spread the risk of failure. In return for taking on this risk through investment, investors in new companies are able to obtain equity and voting rights for cents on the potential dollar. Venture capital, therefore, allows startups to get off the ground and founders to fulfill their vision.

How Risky Is Making a Venture Capital Investment?

New companies often don't make it, and that means early investors can lose all of the money that they put into it. A common rule of thumb is that for every 10 startups, three or four will fail completely. Another three or four either lose some money or just return the original investment, and one or two produce substantial returns.

What Percentage of a Company Do Venture Capitalists Take?

Depending on the stage of the company, its prospects, how much is being invested, and the relationship between the investors and the founders, VCs will typically take between 25 and 50% of a new company's ownership.

What Is the Difference Between Venture Capital and Private Equity?

Venture capital is a subset of private equity. In addition to VC, private equity also includes leveraged buyouts, mezzanine financing, and private placements.

How Does a VC Differ From an Angel Investor?

While both provide money to startup companies, venture capitalists are typically professional investors who invest in a broad portfolio of new companies and provide hands-on guidance and leverage their professional networks to help the new firm. Angel investors, on the other hand, tend to be wealthy individuals who like to invest in new companies more as a hobby or side-project and may not provide the same expert guidance. Angel investors also tend to invest first and are later followed by VCs.

The Bottom Line

Venture capital represents an central part of the lifecycle of a new business. Before a company can start earning revenue, it needs enough start-up capital to hire employees, rent facilities, and begin designing a product. This funding is provided by VCs in exchange for a share of the new company's equity.

Article Sources
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