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. Venture capital doesn't always have to be money. In fact, it often comes as technical or managerial expertise. VC is typically allocated to small companies with exceptional growth potential or to those that grow quickly and appear poised to continue to expand.
Key Takeaways
- Venture capital is a term used to describe financing that is provided to companies and entrepreneurs.
- Venture capitalists can provide backing through capital financing, technological expertise, and/or managerial experience.
- VC 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 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.
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Venture Capital
Understanding Venture Capital (VC)
As noted above, VC provides financing to startups and small companies that investors believe have great growth potential. Financing typically comes in the form of private equity (PE) and may also come as some form of expertise, such as technical or managerial experience.
VC deals generally involve the creation of large ownership chunks of a company, which are sold to a few investors through independent limited partnerships. These relationships are established by venture capital firms and may 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 PE 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.
The potential for above-average returns is often what attracts venture capitalists despite the risk. For new companies or ventures with limited operating history (under two years), VC is increasingly becoming a popular and 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.
History of Venture Capital
Venture capital is a subset of private equity. While the roots of PE can be traced back to the 19th century, VC 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 in 1946 and raised a $3.58 million fund to invest in companies that commercialized technologies developed during WWII.
The corporation'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 2007-2008 Financial Crisis
The VC industry was impacted by the 2007-2008 financial crisis. Venture capitalists and other institutional investors, who were an important source of capital for many startups and small companies, tightened their purse strings.
Things changed after the end of the Great Recession with the emergence of the unicorn. A unicorn is a private startup whose value is over $1 billion. These companies began attracting a diverse pool of investors seeking big returns in a low-interest-rate environment, including sovereign wealth funds (SWFs) and major PE firms. Their entry resulted in changes to the venture capital ecosystem.
Westward Expansion
Although it was mainly funded by banks located in the Northeast, VC 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, the situation has not changed much. During 2022, West Coast companies accounted for more than 37% of all deals (but about 48% of deal value) while the Mid-Atlantic region saw just around 24% of all deals (and approximately 18% of all deal value).
$160 billion
The amount American VC-backed companies raised in 2022.
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 VC 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 VC 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 on debts. This arrangement can be mutually beneficial because 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 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
Provides early-stage companies with capital to bootstrap operations
Companies don't need cash flow or assets to secure VC funding
VC-backed mentoring and networking services help new companies secure talent and growth
Cons
Demand a large share of company equity
Companies may find themselves losing creative control as investors demand immediate returns
VCs may pressure companies to exit investments 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 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 recently retired executives from the business empires they've built.
Self-made investors providing VC 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 while others have a Master in Business Administration (MBA) degree. VC 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 Venture Capital Life
Like most professionals in the financial industry, venture capitalists tend to start their day with a copy of The Wall Street Journal, the Financial Times, and other respected business publications. Venture capitalists who 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 VC 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 their 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 VC 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.
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).
Venture Capital Trends
The first VC 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 investors 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 (SBUX), which both received venture money.
VC is no longer the preserve of elite firms. Institutional investors and established companies 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, VC 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
According to data from the NVCA and PitchBook, 2022 was marked with both highs and lows for the VC industry. Sweeping momentum in the industry carried through from 2021. But it was primarily centered in the first two quarters. VC activity in the final quarter was 25% of what took place in Q1. The VC industry raised about $160 billion for the entire year.
The momentum in this report was due in large part to the zero-to-low interest rate environment that followed during the COVID-19 pandemic and because of Russia's invasion of Ukraine. Silicon Valley Bank was among the rush of institutional investors that began funding startups, particularly in the tech sector. It was very popular with venture capitalists, many of which used the bank to park their cash. But rising rates led to lower deposits by backers, causing winds to shift in the industry. The bank disclosed that it lost about $2 billion from the sale of an investment portfolio, causing customers to pull their money out. The FDIC swept in to take control on March 12.
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.
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.
