What is venture capital? How does it work?
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Venture capital (VC) is a type of financing that provides startups and early-stage businesses with high growth potential with money and usually expertise. Investors provide capital in exchange for preferred-equity ownership in the company.
Here’s more about how venture capital works, its pros and cons and the differences between venture capital and other types of funding.
How does venture capital work?
The process of venture capital begins with a startup pitching to a VC firm that then evaluates the business and conducts due diligence before investing in exchange for equity. After providing funding, venture capitalists may take an active role in the company by offering guidance and support, and possibly serving on the board of directors.
VCs generally try to exit the company within a set period of time, usually by initiating an acquisition, merger or an initial public offering (IPO). In 2022, the median time from initial funding to IPO was 5.1 years for U.S. companies, according to a report from WilmerHale using data from the SEC and PitchBook. However, some companies never make it to an IPO and might fail entirely. On the other hand, a very rare few will become “unicorns” and achieve a $1 billion valuation.
“Venture capital tends to be a particularly risky area of the market, and given this risk, returns for a successful investment can often be quite high,” says James Royal, principal writer, investing, at Bankrate. “However, because of that risk, even savvy VC firms must put their eggs in many different baskets in order to find attractive overall returns on their portfolio.”
“For example, out of a portfolio of 10 companies, five or six may be total losses and two or three may just earn their investment back,” Royal says. “That leaves just one or two investments that drive the total returns of the portfolio. So finding a unicorn is a key driver of total returns.”
Successful investment ventures typically have a strong management team, large market potential and a unique and competitive product.
The 5 stages of venture capital
- Stage 1: Pre-seed capital
- The first stage usually involves raising the initial funding needed to launch a business and is sometimes referred to as the “friends and family” round because investments often come from the founder’s personal network. Money raised in this stage is often used for market research or team expansion.
- Stage 2: Startup capital
- This is the stage where companies receive money from venture capitalists and is also typically known as a Series A funding round. Most businesses release product prototypes to consumers at this stage.
- Stage 3: Early stage
- The money in this stage — often referred to as a Series B round — is largely used to manufacture goods and increase marketing for the business.
- Stage 4: Expansion stage
- Businesses in this stage usually have a solid customer base and a proven track record. Investors are more interested in getting involved with companies in this stage, as investing is less risky here than in earlier stages. Stage 4 can encompass Series C and beyond.
- Stage 5: Mezzanine
- This last phase usually involves an IPO or acquisition. Companies in this stage have usually grown into successful businesses, and investors in this stage will likely sell off their stock to make a profit.
There are five general stages of venture capital financing:
Advantages of venture capital
Venture capital can provide significant advantages to small ventures and startups that struggle to obtain financing through conventional means. Here are some of the benefits.
Gain early financial support
Early-stage companies, which often lack an established track record, can benefit from venture capital by accessing the financing and support needed to turn ideas into profitable ventures.
Exposure to valuable resources
In exchange for potentially high returns on investment, venture capitalists willingly take on investment risks. They not only provide financial support but also offer valuable managerial and technical resources — and their networks — to ensure the success of the investment.
Not obligated to repay
VC funding doesn’t usually require a personal guarantee or collateral. That means that if a startup fails, the founders are not obligated to repay the venture capital investment.
Disadvantages of venture capital
Venture capital, despite its benefits, comes with a few drawbacks.
Loss of controlling equity interest
One significant disadvantage is the potential loss of ownership control for founders. When obtaining funding from venture capitalists, founders may have to relinquish a considerable portion of their ownership.
Time consumption
Securing funding from venture capitalists can be a time-consuming process, which may not be a suitable option for companies in urgent need of cash.
Expectations are high
Future availability of funds can be limited, as venture capitalists often expect a significant return on their investment within a relatively short period, often five years. Subsequent funding rounds may not be readily available after the initial investment. There is also often an expectation for rapid growth, which can add pressure to the company. Underperforming companies that fail to secure additional funding may be forced to shut down their operations.
Limited leverage
Founders may have limited leverage, as venture capital terms heavily favor the investor, although the investor’s participation may be crucial for the success of the business.
Venture capital vs. angel investing
Venture capital and angel investing are both forms of financing for startups and early-stage companies. Unlike angel investors, who typically invest as individuals, venture capital firms pool funds from various sources.
Angel investors are often high-net-worth individuals with entrepreneurial experience who are willing to take on higher risks. They usually invest small amounts compared to venture capitalists and may not require immediate repayment if the venture fails. Angel investors often provide not only funding but also mentorship and advice to the entrepreneurs, leveraging their own expertise and networks.
Sometimes, however, angel investors would rather not have an active role in the startup. While both venture capital and angel investing support startups, venture capital is more institutionalized, involves larger investments and generally comes with a longer-term commitment.
Venture capital vs. private equity
While venture capital is sometimes considered a form of private equity, VC firms target very different companies for investments than private equity firms. Venture capitalists primarily focus on supporting startups, whereas private equity investors typically target established businesses.
Venture capitalists typically seek a minority stake in a company and require a shorter holding period along with their smaller investment. In contrast, private equity investors generally demand a larger ownership percentage and a longer holding period.
Bottom line
Venture capital can be a smart way to finance a business, but before making any decisions, you’ll first want to understand the difference between venture capital, angel investing and private equity. Whichever funding route you choose — and many businesses use a mix of all three — make sure to do your research and consider the potential tradeoffs.
