What is Venture Capital?

Contributor, Benzinga

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Interested in learning more about how the world of venture capital works? Keep reading to find how what venture capital is, how VC investments are made and how you can participate.

Have you ever watched CNBC or another business news network and seen a tech startup make its initial public offering (IPO) on Wall Street? If you have, you remember the company’s founder banging a giant gavel, then drinking copious amounts of champagne while celebrating the fact that the company has gone from an idea to a publicly traded stock. This transformation made the founders millions of dollars in the process.

Well, what you may not realize is that before most tech companies can raise money publicly on Wall Street, they need to raise money privately. The initial fundraising is used to build out the business to the point where it was desirable enough to be traded publicly. Sometimes the company founders raise this money by borrowing from a bank. However, other times, they raise the money through venture capital. 

What is Venture Capital?

Venture capital is exactly what it sounds like; capital raised to fund a business venture, which is typically a startup rooted in some type of tech field. An entrepreneur with a good business idea can pitch it to an angel investor, usually a venture capitalist or a venture capitalist firm (VC firm), to raise the money needed to bring the idea to reality. Usually, startup companies that receive seed funding from venture capitalists or a VC firm trade equity in the startup for the money it receives. 

What Is a Venture Capital Firm?

Traditionally, entrepreneurs raised money for new businesses by borrowing from banks. This model posed some significant problems for people who were pioneering new businesses or ideas that were not yet accepted in the general business arena as “legitimate.” The reason for this is simple; traditional banks are loaning out their client’s money and as such, they prioritize security above profit potential. 

That’s why home loans are known as “secured loans”; because the money the bank is lending is secured by the house. In the event of a borrower default, the bank will foreclose on the house and then sell it to recoup its losses. When it comes to a new business, little actually secures the bank’s money. 

A startup doesn’t typically own the space where it operates from, and it has no history of making money or any assets aside from the computers and desks in the office. That means if the loan goes south, the bank gets left holding the bag. The risk profile of funding startup businesses scares most traditional lenders.

A venture capital firm comes into the picture at this juncture. VC firms exist for 1 reason: to fund startups and new business ventures in exchange for equity in the startup. VC firms are usually led by experienced investors or business professionals with a history of successful endeavors. They pool contributions from other people in their network and seek out growth opportunities by investing in startups, knowing full well that only a few of them will pay off. It’s the ultimate high-risk, high-reward proposition.  

If the startup is successful, the VC firm (and its investors) will have gotten equity in a hot business for pennies on the dollar in comparison to the share price at IPO or subsequent stock offerings. VC firms and venture capitalists in general focus on funding startups in the following fields:

  • Technology (e.g., robotics, artificial intelligence)
  • Biotech
  • Clean energy

How Venture Capitalists Choose Investments

Everyone has heard the saying that “beauty is in the eye of the beholder.” This sentiment is especially true when it comes to venture capitalists choosing investments. A lot of it has to do with how knowledgeable the individual venture capitalist is in the business field that the startup will be entering. With that said however, venture capitalists look for basic characteristics when assessing an investment. 

The most important fundamental for a venture capitalist is risk vs. reward. Several basic tenets make up the risk vs. reward equation:

  • How profitable can the business be if all goes according to plan?
  • How much money does the entrepreneur need to fund the startup?
  • How large is the potential market for the entrepreneur’s product?
  • How likely is it that the startup will fail?
  • Does the entrepreneur or startup founder have a history of success?
  • How much knowledge does the venture capitalist have of the entrepreneur’s chosen field of endeavor?
  • Does the venture capitalist have resources outside of sheer funding that they can bring to bear and help make the startup profitable?

When a VC firm is happy with the answers to most of these questions, it may be inclined to invest. If too many of these questions go unanswered, the firm is less likely to invest or may demand a larger equity share for its investment. 

How a VC Firm Earns a Return on its Investment

Under most circumstances, venture capitalists make what is known as an equity investment in the startups funded. The venture capitalist buys an ownership share in a startup with the seed money it provides. 

So, imagine for a moment that you are a venture capitalist who invests $5,000,000 in a fledgling social media company in exchange for a 25% equity share. The company gets off the ground and does well enough to meet the requirements of the U.S. Securities and Exchange Commission (SEC) for an initial public offering. After the first day of the IPO, the company sells $200,000,000 worth of stock. 

That means the 25% of the company you bought for $5,000,000 is now worth $50,000,000 and you’ve made a $45,000,000 profit, which could be worth even more in the future if the stock continues rising. At this point, you could also sell your shares at a healthy profit, then reinvest some, or all, of that money into new startups. 

However, other methods exist to make a profit through venture capital financing (VC financing). Sometimes venture capitalists make operating loans to a startup in exchange for annual interest, which generates income for the venture capitalist who made the loan. The interest rates for VC financing can be significantly higher than the interest rates charged by banks because of the elevated risk involved with financing startups. 

What Is a Venture Capital Fund?

A venture capital fund gathers contributions from investors with the intention of pooling those funds to invest seed money into various new business ventures. Typically, venture capital funds focus on offering venture capital to a specific type of startup (e.g., tech, transportation, green energy) that operates in a field where the fund’s managers have specific experience. 

These funds actively seek out startups or make themselves available to entrepreneurs seeking funds with the express goal of making early investments into businesses with upside. If the startups become profitable, the fund usually profits from the equity it gained in exchange for providing angel money for the startup.  

Who Can Invest in Venture Capital?

Venture capital investing is complicated, expensive and carries a lot of risk. The truth is, most new companies and startups fail, which means most venture capital investments will not realize their profit potential.  Of course, when venture capital investments do pay off, the money that can be generated in 1 successful startup like Meta Platforms Inc. (NASDAQ: FB) or Amazon.com Inc. (NASDAQ: AMZN) can cancel out years of losses and make investors wealthy beyond their wildest dreams.

Due to the volatility of venture capital and the tremendous amounts of money it often demands, making venture capital investments has traditionally been limited to the wealthiest investors. However, that practice is beginning to change with the advent of startup crowdfunding, which is opening venture capital up to an entirely new class of investors. 

Venture Capital for Retail Investors

When venture capital investing first came into vogue, it was because venture capitalists and VC funds were making tons of money from early investments in tech startups.  Retail investors quickly found out that the size of most venture capital investments combined with the high risk of loss effectively froze them out of the market. 

Fortunately, there is a solution, one that was probably funded by a venture capitalist or VC fund. Startup crowdfunding platforms, which are internet-based websites that allow retail investors to put money into startups, have brought venture capital within reach of everyday investors. These platforms pool smaller individual contributions from retail investors together to directly invest in startup offerings listed on the platform. Other platforms bundle investor contributions into a VC fund, which theoretically will grow money for the investors over time. 

Frequently Asked Questions

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What is the difference between venture capital and private equity?

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What is the difference between venture capital and private equity?
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Venture capital is a form of private equity, but there are significant differences between venture capital and private equity investments. Venture capital and private equity both provide funding for companies seeking funding; however, venture capitalists typically specialize in clean energy, biotechnology or technology startups.

Private equity firms focus on more established companies in a wide range of fields. Additionally, private equity firms tend to buy entire companies whereas venture capital buys equity in startups. Another important distinction between venture capital and private equity is that private equity investments usually entails buying an entire company in full, whereas venture capitalists tend to purchase equity shares in startups ranging from 1% to 50%.

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Q

What do venture capital firms do?

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What do venture capital firms do?
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Venture capital firms provide funding, financial assistance and even specific guidance to startup technology firms, usually in exchange for an equity share in those companies.

Startups seek out venture capital funding because their status as startups and lack of performance history makes them risky propositions for bank loans. Typically, the only “security” startup firms could provide a lending institution is equity in an entirely unproven company in a volatile tech industry.

This elevated risk level is why banks tend to avoid venture capital. However, venture capitalists see this risk as a prime opportunity to get in early on a company with great potential upside. It is however, a high-risk field, which is why venture capital is usually provided by private investors or firms with some experience in the specific field the startup is entering.

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