What Is Venture Capital (VC)?
Venture capital (VC) is a form of private equity and a type of financing for startup companies and small businesses with long-term growth potential. Venture capital generally comes from investors, investment banks, and financial institutions. Venture capital can also be provided as technical or managerial expertise.
Key Takeaways
- Venture capital (VC) is a form of private equity and a type of financing for startup companies and small businesses with long-term growth potential.
- Venture capitalists provide backing through financing, technological expertise, or managerial experience.
- VC firms raise money from limited partners (LPs) to invest in promising startups or even larger venture funds.
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Understanding Venture Capital (VC)
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). Ownership positions are sold to a few investors through independent limited partnerships (LPs). Venture capital tends to focus on emerging companies, while PE tends to fund established companies seeking an equity infusion. VC is an essential source for raising money, especially if start-ups lack access to capital markets, bank loans, or other debt instruments.
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.
VC became synonymous with the growth of technology companies in Silicon Valley on the West Coast. By 1992, 48% of all investment dollars went into West Coast companies; Northeast Coast industries accounted for just 20%. During 2022, West Coast companies accounted for more than 37% of all deals while the Mid-Atlantic region saw just around 24% of all deals.
Types of Venture Capital
- 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.
$285 billion
The amount global VC-backed companies raised in 2023.
How to Secure VC Funding
- Submit a Business Plan: Any business looking for venture capital must submit a business plan to a venture capital firm or an angel investor. The firm or the investor will perform due diligence, which includes a thorough investigation of the company's business model, products, management, and operating history.
- Investment Pledge: 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.
- Exit: The investor exits the company after some time, typically four to six years after the initial investment, by initiating a merger, acquisition, or initial public offering (IPO).
Many venture capitalists have had prior investment experience, often as equity research analysts. VC professionals tend to concentrate on a particular industry. A venture capitalist who specializes in healthcare, for example, may have had prior experience as a healthcare industry analyst.
Advantages and Disadvantages of Venture Capital
Venture capital provides funding to new businesses that 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. VCs often provide mentoring and networking services to help them find talent and advisors. A strong VC backing can be leveraged into further investments.
However, a business that accepts venture capital support can lose creative control over its future direction. VC investors are likely to demand a large share of company equity, and they may make demands of the company's management. 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
Angel Investors
Venture capital can be provided by high net-worth individuals (HNWIs), also often known as angel investors, or venture capital firms. The National Venture Capital Association is an organization composed of venture capital firms that 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 business empires. 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. 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.
Venture Capital Success
Due to the industry's proximity to Silicon Valley, the overwhelming majority of deals financed by venture capitalists occurred in the technology industry—the internet, healthcare, computer hardware and services, and mobile and telecommunications. In 2023, San Francisco still ranked highest among VC investments. Other industries have benefited from VC funding, including Staples and Starbucks (SBUX).
Google and Intel have venture funds to invest in emerging technology. In 2019, Starbucks also announced a $100 million venture fund to invest in food startups. VC has matured over time and the industry comprises an assortment of players and investor types who invest in different stages of a startup's evolution.
Why Is Venture Capital Important?
New businesses 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 can 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 Is Late Stage Investing?
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 higher.
How Have Regulatory Changes Boosted VC?
The Small Business Investment Act (SBIC) in 1958 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%. 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. The capital gains tax was reduced to 20% in 1981. These 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 Bottom Line
Venture capital represents a central part of the lifecycle of a new business. Before a company can start earning revenue, it needs 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.
