Venture capital (VC) investing isn't something the average person engages in, but this form of investing plays an important role in the financial system and overall economy.
VC is a subset of private equity that involves investing in privately owned startups or early-stage companies, which often have a higher risk/reward profile than more established companies.
In many cases, VC investing is oriented toward tech companies, as these often have the potential for outsize growth, but a VC investment could technically be in any category that a VC investor thinks is worthwhile. Still, there's often a tech angle, like fintech companies disrupting finance or healthtech companies disrupting healthcare.
Matt Malone, the head of investment management at Opto Investments, explains, "These companies may not have a proven product or revenue stream, so traditional funding sources are not an option for them. Venture capitalists are willing to assume and manage the risks associated with startups."
In exchange for this investment, VC investors typically obtain equity in that company, with the goal being to sell the stake later on as the company's valuation grows, such as by later being acquired or going public via an IPO. Unlike some other private equity investments, however, VC investors usually only buy slices of companies as part of funding rounds, rather than buying whole companies.
These investments generally are made via VC funds, which are managed by VC firms that pool money from other investors — usually high-net-worth investors or institutions — and the funding helps startup founders gain the capital they need to fuel growth, such as hiring more staff, expanding into new markets, etc.
Many of the companies that you use today and that play important roles in our economy and society started as emerging companies that took on VC investment, such as Google, Facebook, and Uber.
Here's everything you need to know about venture capital, VC funds, and more.
How venture capital works
VC is an alternative investment, like hedge funds or managed futures, often only available to certain high-net-worth investors and institutions. Keep in mind that investing in venture capital comes with significant risk and complexity compared to traditional investments, and thus investment is generally open to a smaller pool of qualified investors.
The key players in VC investing include:
Accredited investors
To qualify as an accredited investor and have more open access to VC investments, you have to meet criteria, such as having an annual income of at least $200,000 ($300,000 for married individuals) for the past two years with a reasonable expectation to do so in the current year.
That said, certain regulatory changes have slightly opened up venture capital investment, such as how nonaccredited individuals can invest through crowdfunding platforms, like:
- EquityNet
- Fundable
- CircleUp
- SeedInvest
- StartEngine
- Yieldstreet
- Crowdrise
- Groundfloor
However, the SEC limits the amount nonaccredited investors can contribute toward alternative investments, which VC falls under. The amount you contribute depends on your individual net worth and annual income. Accredited investors don't have this limit.
"Most countries regulate who and how someone may invest in private offerings," explains Malone. "These regulations are designed to ensure that investors have the financial sophistication and means to both understand and assume the risks associated with these investments."
Venture capital firms
While accredited investors are generally eligible to make VC investments, the process for doing so typically involves going through a venture capital firm.
Venture capital firms are companies that create and manage venture capital funds. Think of how a mutual fund generally has a company behind it, e.g., there are several types of mutual funds run by Fidelity. So, the VC firm is analogous to Fidelity, and the VC firm then runs several particular types of VC funds.
Some of the top venture capital firms are:
- Sequoia Capital
- Andreessen Horowitz
- Accel
- Kleiner Perkins
- Bessemer Venture
- Intel Capital
- New Enterprise Associates
Venture capital funds
VC firms create venture capital funds, which pool money from investors like high-net-worth individuals, pension funds, and endowments to then make investments in other companies.
Typically, these are equity investments in startups and early-stage companies with long-term growth potential, though some funds provide loans, known as venture debt (which is sometimes considered a separate category). Regardless, instead of investing in a single startup, venture capital funds invest in multiple companies, and they usually hold these investments for six to 10 years.
Venture capital funds tend to follow a particular investment thesis/theme that targets a section of the market or a certain stage of investment. Depending on the maturity of the business, venture capital investments are either considered seed capital, early-stage capital, or expansion-stage financing.
Managers of venture capital funds are called general partners (GPs) and are in charge of selecting investments, raising capital from outside investors, and performing accounting and legal operations.
"The GP develops the fund's investment strategy. This includes the industries and types of companies that they will invest in, such as technology, consumer goods, etc. The strategy may define whether the investments are targeting seed, early-, mid-, or late-stage companies," says Malone.
The investors in a VC fund, such as pension funds and high-net-worth individuals, are known as limited partners (LPs), as they're providing capital but not running the fund.
Typically, LPs have to be accredited investors. The minimum needed to invest in a venture capital fund varies by fund. Minimums can range, for example, anywhere from $1,000 to $500,000 or higher.
Also, VC funds charge LPs fees, which roll up into the VC firm's bottom line — e.g., a firm may have several different types of funds and its overall profitability is based on the total fees collected.
"These funds may vary in size from a few million to several billion dollars, depending on the strategy," says Malone.
A popular fee structure for venture capital funds is the two and twenty model, which is when a VC firm annually charges a 2% assets under management (AUM) fee and a 20% performance fee that's based on the fund's returns above a given benchmark.
"VC firms get paid to provide their expertise in identifying and evaluating potentially promising startups. They are looking for innovative ideas that solve a real problem and capable founders who can make those ideas a reality," says Malone.
Some VC funds also charge fees to the companies they invest in, such as advisory fees, depending on the relationship.
Venture capital vs. private equity
Private equity refers to investment in private companies and business ventures such as leveraged buyouts, distressed funding deals, and specialized limited partnerships. Venture capital is considered a type of private equity, but some categorize them separately to avoid confusion.
While many of the investment characteristics overlap, venture capital and private equity (as a separate category) tend to target different companies and have different investment approaches. Private equity often invests in more established businesses, whereas venture capital specifically invests in startups and early-stage companies.
Another key difference is that venture capital investments tend to be for minority ownership stakes in companies, meaning they acquire less than 50% and might be one of several other VC firms investing in that company, whereas non-VC private equity traditionally involves buying majority stakes in companies and engaging in more hands-on management of these companies they own.
Investment process
The investment process for VC starts with deal sourcing, both in terms of VC firms looking for promising young companies to invest in, along with these companies often making the rounds to different VC firms.
During this process, startups pitch their business plans and let VC firms know they're open for funding, often through formal funding rounds where companies request a certain amount of money for a certain amount of equity in the company, which implies a certain valuation for the company. If you've seen the show Shark Tank, that's basically what's happening behind closed doors at VC meetings, albeit with less drama perhaps.
VC firms will then conduct an extensive analysis of the proposed plan, company financials, and other key data — known as doing due diligence — to determine the quality of the potential investment. VC firms may also examine personal information, such as founders' professional experience, educational background, and other relevant information
If the VC firm decides to make an investment, they'll finalize the terms of the deal, often alongside other VC investors who are participating in that funding round. The VC firm may also become more hands-on in the day-to-day operations of the companies they invest in, known as portfolio companies.
"Once they invest, the fund managers take an active role in supporting their portfolio companies. They provide guidance, expertise, and regular monitoring to ensure that their companies are growing, " states Malone. "Further support comes from large networks, which they can use to connect startups to potential customers, suppliers, and others who can help accelerate growth."
Ideally, with the help of the VC firm's capital and guidance, alongside a company's own success, there will be an opportunity several years after the initial investment for the VC firm to exit. This exit could be accomplished by selling shares to another investor such as another VC fund or bank, getting bought out as part of a portfolio company getting acquired, or via the portfolio company going public, enabling the VC firm to sell shares on the open market. Sometimes, though, VC firms are content to hold profitable companies that generate payouts via dividends; usually, however, since portfolio companies are in growth mode, they're not profitable yet.
Stages of venture capital funding
There are different stages of VC funding that correspond to a company's maturity. Typically, a fund sticks to one or two of these stages, rather than investing in companies of all different sizes. These stages include
Pre-seed funding
The first stage of funding — also called the friends and family stage — is when a startup or small business obtains funds from the founder's personal network, which often consists of friends and family. In some cases, a VC investor gets involved in pre-seed funding, such as if a small VC firm runs a fund that tries to get in on the ground floor. That said, sometimes those making these pre-seed investments are considered to be angel investors, not VC investors. The lines are a bit blurry, but the point is that these are usually small, early investments to get the ball rolling.
Seed funding
The seed funding round is usually the first formal funding round, which often involves VC funds providing capital to startups so that they can develop prototypes or essentially get their business from concept to minimum viability. Seed round investments are usually in the range of several hundreds of thousands of dollars to a few million, but again, the lines are a bit blurry. Keep in mind that a VC fund might not provide all of the funding for any given round but instead take part in that investment alongside several other firms.
Series A funding
Once a business has its legs under it and is starting to grow, the Series A funding round comes next to help fuel the next leap. These funding rounds generally range from around $2 million to $15 million, but again, a VC fund might not provide all of that itself. Perhaps five VC funds each invest $2 million as part of a Series A, for example. The funding size also depends greatly on the specific company raising money and the investors it attracts.
Series B funding
When a company reaches the Series B stage, it's generally already gained significant traction and has millions in revenue. While VCs often still participate in this stage, they might face competition from other investors such as traditional private equity firms and investment banks who are starting to get involved now that the company has begun to establish itself. These funding rounds often range from around $10 million to $30 million, though it can vary quite a bit.
Late-stage funding
After the Series B, startups often continue to raise money through subsequent funding rounds, like Series C and Series D, that progressively get larger and start to attract more mainstream investors, so VC investors tend to fade out (though they may still hold portfolio companies that have reached these later stages, just perhaps not make new investments.)
As companies progress through late-stage funding, they often look for an exit event, either by getting acquired or going public via an IPO, which gives early VC investors the opportunity to liquidate their stock.
"When the companies are ready for an exit, the fund managers will help them prepare for a sale or potential initial public offerings. Investors (LPs) are paid the capital remaining after the manager and fund expenses are paid," says Malone.
Benefits of venture capital
Venture capital provides several potential benefits to both investors and those receiving VC investment, such as:
Potential for high growth
The funding from VCs gives portfolio companies crucial capital that they can use to stock up on inventory, advertise, hire staff, or anything else they want to use the funding for. That can lead to substantial growth, especially considering the starting point. For example, if a VC fund invests in a company that uses the capital to grow from a $1 million to $2 million valuation, that's a 100% return.
Expertise and guidance
Because VC investors often take more of a hands-on role with their portfolio companies than traditional stock owners, they can help startup founders gain a competitive advantage and overcome obstacles that new companies often face. That can help in terms of investment performance, and VC investors also might like the idea of being able to shape early-stage companies. Keep in mind, though, that LPs generally don't have a hands-on role, just the GPs.
Diversification
VC investing can provide investors with diversification, as even though this is typically a form of equity investing, VC returns aren't always correlated with public stock market returns.
For example, if the stock market is struggling due to a slowdown in consumer spending, it's possible that VC funds are still doing well. Perhaps the portfolio companies they're investing in are developing technologies that will affect consumers several years from now, and thus temporary swings in consumer spending don't have much of an effect. Instead, the VC returns might be based on the underlying companies' technological success and ability to attract new investment.
Risks of venture capital
While there are several possible advantages to VC investing, it can come with downsides for investors and the portfolio companies themselves.
Potential for large losses
The flip side of high potential returns is the risk of large losses.
"Venture capitalists invest in seed and early-stage companies that are inherently risky, as they generally have yet to find a product-market fit and are frequently operating at a loss at the time of investment," states Malone.
There are various things that can go wrong in a venture capital investment. As Malone further explains, "portfolio companies may underperform or fail for many reasons. The market for the company's products may shift or disappear. The founders may not be able to execute the plan, or an exit may not be possible."
Fees
Investing in VC typically comes with much higher fees than public equities. To some, the fees are worth it for the potential gains, but it's important to consider how these can cut into returns.
Dilution
With public equities, the pool of stock is relatively stable. But with early-stage investments like venture capital, your equity will likely get diluted over time — both from the perspective of founders raising VC funds and VC investors who might start with a given percentage of a company but then own less over time as new investors buy in.
This dilution tends to balance out by the valuation increasing, so owning a smaller percentage isn't necessarily a problem if the total value of that equity grows. However, sometimes companies go through down rounds that reduce valuations, and owning a smaller percentage also means giving up control over the company.
How to secure venture capital funding
If you have a startup and want to secure VC funding, consider steps like the following:
Develop a strong business plan
You don't have to have a certain amount in sales to attract VC funding, but you do need a clear, strong business plan that indicates your path to success.
Build a minimum viable product (MVP)
While some early VC investments are made before a company can even build a prototype, it often helps to have an MVP that can demonstrate how your product or service works and that it can attract users.
Gain traction
While it's easier said than done, the more you can do to show your company is gaining traction, the easier it typically is to secure VC funding.
This doesn't have to strictly mean making sales, though that helps. It could also be something like attracting a large social media following for your brand to show that you have good marketing reach and potential for more sales.
Network with VCs
You might not be able to meet with every VC of your choice, but you can start to build your own network, such as by engaging with VC firm partners on LinkedIn and attending any industry events in your area where VC investors might be, such as new tech conferences.
Prepare a pitch deck
Before you actually meet with VCs, prepare a pitch deck that provides a succinct yet compelling presentation of what your business does and why VCs should invest in it.
FAQs about venture capital
How much equity do VCs typically take?
The amount varies depending on the situation, but typically VCs acquire minority stakes in companies, often totaling around 10-20% per funding round.
What are the key criteria VCs look for in a startup?
While the criteria can vary by VC firm and the type of company under consideration, VCs often look at areas such as the business plan, current sales, projected sales, market opportunity, competitors, and the founder's history.
How do I find the right VC for my business?
Finding the right VC for your business often requires researching firms that invest in companies like yours and meeting with different firms to determine who seems like the right fit.
