Venture capital doesn’t gain much attention among the public, but it’s behind many of the brands most of us engage with daily. Any consumer who logs on to Facebook or listens to their favorite song on Spotify is engaging with a company that once received financial funding from a venture capital firm.
At year-end 2020, approximately 1,965 U.S. venture capital companies held about $548 billion in venture capital assets. Additionally, the U.S. is a huge player in the VC market, holding over 51% of all invested venture capital
Why is venture capital so pervasive in the U.S. economy and what does it mean for both companies seeking financing and the customers they sell to? Here’s a deeper dive on venture capital, from multiple angles.
What is Venture Capital?
Venture capital is money used to fund startups and invest in private companies that exhibit the characteristics investors seek—namely long-term growth and a product or service with robust profit potential.
Venture capital (or VC, as it’s often called) is a huge force in the business funding market. In 2020, when a worldwide pandemic disrupted the U.S. economy, venture capital companies raised over $130 billion to fund new business startups, with more than 10,000 U.S. businesses receiving financial capital.
What is a Venture Capital Firm?
A venture capital firm is a company that looks for both interested investors and potential companies in which to invest. Venture capital can be critically important to startup firms, as traditional banks may be risk-averse in providing new business funding, given the relative high level of risk in picking winners in a highly competitive market environment.
The concept of venture capital firms dates back to the 1940’s, when a handful of fledgling private equity groups funded emerging companies. The VC sector accelerated in the 1970’s, in tandem with the dynamic growth of the US technology sector, and as government public policy made it easier for venture capital firms to develop and begin funding new businesses.
What’s the Difference Between Venture Capitalists and Angel Investors?
It’s important not to confuse venture capitalists with angel funding investors.
By and large, venture capitalists work for an established financial funding company working with limited partners to locate potentially profitable emerging companies.
Angel investors, on the other hand, are more likely to be “lone wolf” individual investors who rely on their own cash to fund companies.
Recommended: A Closer Look at Angel Investors and How to Find Them
How Does Venture Capital Work?
Venture capital starts with money—and lots of it.
A venture capital company will open a fund and start looking for qualified investors, otherwise known as limited partners. These partners, often banks, corporations or investment funds, agree to buy into the fund and invest in young companies with profit potential. In exchange for the funding, venture capital firms will give the limited partners minority equity in the company (i.e., below 50%), with the amount dependent upon how much money the partners have invested with the firm.
Once a financial commitment is obtained from enough limited partners, the venture capital firm sets out to identify promising companies. Typically, a VC funding campaign is thorough, with the venture capital firm taking a sharp look at the company’s business model, executive team, revenue history, product or service offered, and its long-term growth potential.
What Are the Stages of VC Funding?
If there’s mutual interest, the VC firm will likely offer the target company funding at different tiers, as follows:
Seed Stage
Seed stage money is usually offered to early-stage businesses with a limited amount of funding on the table.
The company, which needs cash to grow, can use the seed-stage venture capital funding for myriad uses, including research and development, product testing and development, or even to create a concrete business plan. In return, the venture capital company will likely require a stake in the company in the form of convertible notes, preferred stock options, or private equity. While funding amounts vary widely, the average seed stage funding amount was $2.2 million in 2020.
Early Stage
With early-stage funding, VC firms will pour more cash into a company, typically once that company has a solid product or service in the pipeline and ready to roll.
VC firms usually fund early-stage companies in letter tiers, starting with Series A, then moving on to Series B, Series C, and Series D. The average early-stage funding amount also varies by company, but the “A level” early-stage funding average clocked in at $12 million in 2020.
Late Stage
With late-stage funding, VC firms focus on more mature businesses that have a track record for growth and revenues, but need a big cash infusion to get to the next level. The funding level at the late stage is also rolled out in lettered tiers, with the median late-stage funding figure at $70 million in late 2020.
After the late-stage funding is complete, expectations are typically high that the company will flourish. That hopefully leads to a profitable acquisition or an initial public offering (IPO), where the company issues stocks, goes public, and lands on a stock market exchange.
While the time frame for exiting a company varies from VC firm to VC firm, generally the goal is to turn a significant profit via an IPO or acquisition and exit the funding position in a four-to-six year time frame.
The Takeaway
Venture capital firms use money from qualified investors like banks, corporations, or investment funds to invest in promising startups or small businesses, with the goal of turning a profit within four to six years.
When the process goes according to plan, a venture capital deal can work out well for both the VC firm and the company receiving the funding. Start-up businesses gain the benefit of cash and experience while the VC firm gets a crack at a major financial return on its investment.
For individual investors, VC funds may be out of reach—but that doesn’t mean you can’t dive into the investing pool. With SoFi Invest®, members can trade stocks online, ETFs, crypto, and Pre IPO investments.
Photo credit: iStock/Pekic
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