Every great company starts with a great idea, but even the best ideas don’t go far without money. It takes ample financing for a start-up to get from vision to execution, and for many entrepreneurs venture capital provides critical financial support in the initial stages of growth.
What is Venture Capital?
Venture capital (VC) is a form of private equity that funds start-ups and early-stage emerging companies with little to no operating history but significant potential for growth. Fledgling companies sell ownership stakes to venture capital funds in return for financing, technical support and managerial expertise.
VC investors typically participate in management, and help the young company’s executives make decisions to drive growth. Start-up founders have deep expertise in their chosen line of business, but they may lack the skills and knowledge required to cultivate a growing company, while VCs specialize in guiding new companies.
Venture capital offers entrepreneurs other advantages. Portfolio companies get access to the VC fund’s network of partners and experts. Moreover, they can depend on the VC firm for assistance when they try to raise more money in the future..
Venture capital is an alternative investment that’s typically only available to institutional and accredited investors. Pension funds, big financial institutions, high-net-worth investors (HNWIs) and wealth managers typically invest in VC funds.
How Does Venture Capital Work?
Venture capital firms provide funding for new companies in the early stages of development. In return for funding, a VC firm takes an ownership stake that’s typically less than 50%. A VC fund’s goal is to increase the value of the start-up, then profitably exit the investment by either selling their stake or via an initial public offering (IPO).
There are four types of players in the venture capital industry:
- Entrepreneurs who start companies and need funding to realize their vision.
- Investors who are willing to take on significant risk to pursue high returns.
- Investment bankers who need companies to sell or take public.
- Venture capitalists who profit by creating markets for the entrepreneurs, investors and bankers.
Entrepreneurs looking for capital submit business plans to VC firms in the hope of obtaining funding. If the VC firm considers the business plan to be promising, it will conduct due diligence, which entails a deep dive into the business model, product, management, operating history and other areas pertinent to assessing the quality of the business and idea.
Regardless of how far along the business is, a VC firm also takes a deep look at the principals—everything from their education and professional experience to relevant personal details. Extensive due diligence is vital to making good investment decisions.
If the due diligence process is successful and the growth outlook for the business is promising, the VC firm will offer capital in exchange for an equity stake. Often, capital is provided in multiple rounds and the VC firm will take an active role in helping run the portfolio company.
Stages of Venture Capital Investing
As portfolio companies grow and evolve, they pass through different stages in the VC process. Some venture capital funds specialize in particular stages, while others may consider investing at any time.
- Seed round funding. This is the first round of VC funding, in which venture capitalists offer a small amount of capital to help a new company develop its business plan and create a minimum viable product (MVP).
- Early stage funding. Typically designated as series A, series B and series C rounds, early stage capital helps start-ups get through their first stage of growth. The funding amounts are greater than the seed round, as start-up founders are ramping up their businesses.
- Late stage funding. Series D, series E and series F rounds are late-stage VC funding. At this point, start-up companies should be generating revenue and demonstrating robust growth. While the company may not yet be profitable, the outlook is promising.
The VC firm’s objective is to grow their portfolio companies to the point where they become attractive targets for acquisitions or IPOs. The venture capital firm aims to sell off its stakes at a profit and distribute the returns to its investors.
What Are Venture Capital Funds?
Like other types of private equity funds, venture capital funds are structured as limited partnerships. General partners manage the fund and serve as advisors to the fund’s portfolio companies. Investors in the fund are limited partners.
A venture capital fund makes multiple investments in a stable of promising companies. They tend to take minority stakes of less than 50% in their portfolio companies, with the goal of increasing their value. Exit strategies include selling the portfolio company to another public company or taking the portfolio company public. The VC firm can also sell shares in the portfolio company on the secondary market.
Venture capital funds generate revenue by charging management and performance fees. The most common fee structure is two and twenty: The VC firm charges its investors a management fee of 2% on total assets under management (AUM), plus a performance fee equal to 20% of profits.
Well-Known Venture Capital Funds
Venture capital funds invest in many industries, but most VC investments are concentrated in the tech sector. Many of the most well-known VC firms are based in Silicon Valley, although they can be found throughout the U.S. Some of the most prominent VC funds include:
- Andreesen Horowitz. Founded in 2009 by Marc Andreesen and Ben Horowitz, Andreesen Horowitz is based in Menlo Park, Calf. This VC fund invests in early-stage start-ups and growth companies in sectors like enterprise IT, gaming, social media, ecommerce and cryptocurrency.
- Sequoia Capital. One of the top VC firms in the world, Sequoia is also based in Menlo Park, Calf. Sequoia Capital has invested in some of the best-known tech companies in the U.S., including WhatsApp, LinkedIn, PayPal and Zoom, among others.
- Combinator. Launched in 2005, this VC fund and start-up accelerator is regarded as one of the most successful start-up accelerators in Silicon Valley. It has invested in more than 3,000 companies, including Door Dash, Coin base, Instacart, Dropbox and Reddit, among many others.
Private Equity vs. Venture Capital
As noted above, venture capital is considered a form of private equity. The clearest difference between them is that venture capital supports entrepreneurial ventures and start-ups, while private equity tends to invest in established companies.
Venture Capital
- Invests in start-ups
- Typically acquires stakes that are less than 50% of a company’s equity
- May participate in the management of portfolio companies
- Extremely popular in the tech sector
- Invests in companies that have yet to generate significant revenue or profits
- Generates a return when a portfolio company is sold or taken public
Private Equity
- Invests in established businesses, and often prefers financially distressed companies
- Takes a majority stake in portfolio companies
- Almost always participates actively in management and operation of portfolio companies
- Generates a return when the portfolio company is sold or taken public
How to Invest in Venture Capital
Venture capital investing has traditionally been limited to accredited investors and institutional investors. Investing in VC funds demands a substantial financial commitment and the ability to conduct in-depth due diligence.
Retail investors who follow the venture capital industry can benefit from insights that inform their future investment decisions. VC investors frequently focus on new industry segments that may become engines of growth down the line. Paying attention to these developing businesses and industries can give retail investors ideas for their own strategies.
Rayol Hwang, the chief executive officer of Hillstone Partners, recently argued that retail investors should play a bigger role in venture capital investing in the future.
“Using smart contracts and tokenization, venture capital can be made accessible to all retail investors,” said Hwang.
The firm is set to launch Hillstone Finance, which will leverage blockchain technology to offer investment opportunities that are typically off limits to retail investors.
In the UK, efforts are also being made to give retail investors access to venture capital. Forward Partners, a VC company based in the UK, included retail investors in an IPO conducted earlier this year.
