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

By Brian O'Connell · May 18, 2024 · 8 minute read

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

Venture capital is a type of financing that’s usually provided by wealthy individuals or investment banks. Venture capital often funds startups or other small businesses, and is a form of alternative investment – for those with the means.

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.

Key Points

•   Venture capital is a form of private equity financing provided by high-net-worth investors and financial institutions to startups and small businesses with high growth potential.

•   This type of investment often includes not just monetary support but also technical assistance and managerial expertise.

•   Venture capital firms play a crucial role by connecting investors with high-potential companies, especially in environments where traditional banking support is limited.

•   The funding process involves multiple stages, including seed, early, and late stages, each catering to different development phases of a company.

•   Despite the high risks associated with venture capital investment, the potential for substantial returns makes it an attractive option for qualified investors.

What Is Venture Capital?

As noted, venture capital (VC) is a form of private equity financing typically provided by high-net-worth investors, investment banks, and other financial institutions. This type of funding is focused on startups and small businesses that demonstrate potential for significant long-term growth. In that sense, it’s a form of alternative investment.

VC can be monetary, but can also come in the form of technical assistance or managerial expertise. It is a great way to support businesses just starting out, offering them the potential to expand and succeed. In return, venture capitalists are offered ownership stakes in the company, creating a win-win partnership with the potential for both parties to benefit.

Venture capital (or VC, as it’s often called) is a huge force in the business funding market.

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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.

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What’s the Difference Between Venture Capitalists and Angel Investors?

Venture capitalists provide funding to startup enterprises on behalf of a risk capital firm, utilizing external funds. On the other hand, angel investors are affluent individuals. often referred to as “lone wolves,” who invest their own capital in entrepreneurial ventures.

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.

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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. Funding amounts tend to vary widely.

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.

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.

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.

Can I Invest in Venture Capital Funds?

The average investor may find it difficult to get involved in venture capital investing, as a requirement is that investors meet certain criteria – they must be an accredited investor, which means they have a high annual income and a high net worth (more than $1 million).

However, investors can invest in stocks that are involved in venture capital, or they can look at specific types of funds that open up venture capital to average investors. That can include interval funds, which are a type of alternative investment that may give investors exposure to off-market capital – they don’t trade on the secondary market, and as such, may be tricky to track down and add to your portfolio.

It may be a good idea to speak with a financial advisor or professional to get a sense of what other potential options may be open to you for investing in venture capital, too.

What Are the Risks Associated with Venture Capital Investing?

Venture capital investing can be particularly attractive because of the big potential rewards – but those are paired with significant risks, too.

As for those risks, venture capital entails significant market risk, as it involves investing in small businesses and startups that have a high chance of failure. Further, there’s operational risk (that those startups won’t be able to perform as hoped) and financial risks that are associated with small businesses, too. For investors, there’s also liquidity risks, as it can be difficult to get your money back or out once it’s been deployed.

But again, the rewards may make up for those risks for some investors. There’s high return potential if you back a successful startup, and being an early-stage investor can also open up personal and professional connections in the company and a specific industry. That, too, could lead to further investment opportunities.

Are VC Investments Regulated?

Venture capital and private equity are regulated by the SEC, and venture investments, specifically, are generally subject to many of the same investment regulations as other types of investments. For instance, there are reporting requirements that may be involved, “know-your-customer” (KYC) regulations, and rules regarding the Bank Secrecy Act – concerning fraud and money laundering issues – that venture firms need to abide by.

Are Venture Capital Firms Focused on Technology?

Many venture capital firms are focused on the tech sector, but not all. Over the past decade or two, technology has been a high-growth industry, which has, in turn, attracted a lot of investor attention, including VC attention. But venture capital firms can invest in just about anything, and just about anywhere.

In recent years, the number of VC investments and the proceeds have fallen as economic conditions have grown tighter, with higher interest rates and more risk aversion among investors and businesses. But the lion’s share of VC investments are still concentrated in the tech sector, along with sectors such as industrials, health care, financials, and more.

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.

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