What Is Venture Capital?
Venture Capital Explained
Venture capital is a type of investing in which wealthy individuals and organizations contribute to a startup in exchange for partial ownership in the company. Venture capitalists take on a significant amount of risk by financing these new companies, and therefore expect a large potential return.
Venture capital, sometimes referred to as “VC,” isn’t the only way new companies can get funding. Advancing technology has made it easier for companies to obtain financing through nontraditional means and for individual investors to participate more freely. Learn how venture capital works, some different types, and about alternative sources of investment.
What Is Venture Capital?
Venture capital is a type of business financing in which a new or small company seeks the help of investors to start or grow. With this form of funding, venture capital firms can get in on the ground floor of companies they believe will succeed.
New companies often need access to capital to help them get off the ground. But without a proven track record, traditional means of financing may not be available. That’s where venture capital comes in.
A venture capitalist is the investor who puts up the money for this type of business deal. In some cases, venture capitalists are wealthy individuals. But they are also often pension funds, insurance companies, endowments, and other financial institutions that take part in venture capital funds in search of high returns on their investments.
How Venture Capital Works
Venture capital involves institutions and wealthy individuals investing in startups and early-stage companies in exchange for equity, or ownership, in the company. Venture capital funds usually serve as the middleman in these deals.
Investors give their money to the fund, and the fund provides money to the companies they are financing. The venture capital fund typically provides anywhere from a few million dollars to tens of millions in exchange for a percentage of equity. In addition to financing, the venture capital fund may play an active role in the company, offering its feedback and expertise.
The beneficiaries of venture capital dollars are typically startups that are too young, small, or underdeveloped for an initial public offering (IPO). Because they don’t have a proven track record, many traditional financing mechanisms aren’t available to them. Additionally, they might wish to avoid selling their shares publicly and prefer a more private transaction.
Venture capital is a high-risk investment for those providing the financing. The companies they’re investing in aren’t well-established and have a substantial risk of failing.
Investors are often putting their trust in a person or an idea more than an actual product. In exchange, investors expect a larger return than they may get from more traditional investment opportunities.
Types of Venture Capital
Venture capital describes individuals or institutions investing in new or growing companies. But there are different types of venture capital that describe the stage a business is in and its financing goals.
- Seed Capital: This type of venture capital funding helps new companies get off the ground. Those receiving this funding often don’t have an established product or organization yet, and the money often helps them to create their product or fund their market research.
- Startup Capital: Venture capital at this stage is for companies with a product to sell, but may not be fully off the ground. This funding helps companies to grow their team and get their product into the marketplace.
- Early-Stage Capital: After two or three years in business, this type of venture capital helps companies to improve their processes in order to manufacture and sell their product more efficiently.
- Expansion Capital: Well-established companies use this type of venture capital funding to take their business to the next level. Funding can help these companies to grow their marketing efforts and expand into new markets.
- Late-Stage Capital: Venture capital isn’t necessarily just for new companies. Successful businesses can use this type of venture capital to increase cash flow and continue to grow.
- Bridge Financing: This type of venture capital serves as a temporary source of funding while a company waits for a larger, more permanent one. Companies might use bridge financing before an IPO or a merger or acquisition.
Alternatives to Venture Capital Funding
Venture capital is one way for early-stage companies to obtain the funding they need to get off the ground, but it’s not the only way. There are an increasing number of methods companies can choose to raise capital.
Angel investors are high-net-worth individuals who get in on the ground floor of businesses they see potential in. Unlike venture capitalists, which are often institutions, angel investors are frequently individuals who bring their business experience and advice to the table. They may be willing to take on more risk because they become active participants in helping the company to reach its goals.
Crowdfunding is a form of financing that has emerged in recent years where many people pool their money together online. Companies sign up for a crowdfunding website and make their pitch, and then anyone can contribute. Unlike angel investing and venture capital, it’s not just wealthy individuals who invest in companies in this way. While many types of business financing involve giving away equity in your business, crowdfunding is often incentive-based. People contribute in exchange for a particular reward, such as a first edition of the company’s product.
Debt financing occurs when companies borrow money to help them get off the ground. Rather than investors, companies seek out lenders. And rather than turning over equity in their company, borrowers must pay back the loan with interest. Many financial institutions offer business loans and lines of credit to companies. For those companies that aren’t established and have no assets, the business owner personally guarantees the loan, meaning they promise to pay back the loan if the business can’t.
Venture Capital vs. Private Equity
Both venture capital and private equity are types of business financing that move money from the hands of investors into the accounts of businesses. And while the two have similar goals, their methods differ.
While private equity is another type of private business financing, it often involves the private equity firm buying 100% ownership of the company, while venture capitalists often remain minority investors. Private equity typically involves much larger investments for a significantly smaller risk.
|Venture Capital||Private Equity|
|Business stage||Early-stage||Mid- to late-stage|
|Investment size||Millions to tens of millions||Hundreds of millions to billions|
|Type of investment||Equity, convertible debt||Equity|
|Risk level||High risk||Moderate risk|
|Expected rate of return||10x or higher||15% or higher|
Pros and Cons of Venture Capital Funding
- Potentially high returns for investors
- Available to companies that are too young for an IPO
- Access to the business expertise of venture capitalists
- High risk for investors
- Loss of partial equity
- Loss of control and decision-making power
- Potentially high returns for investors: Because venture capitalists invest early in a startup, they have the potential to make a lot of money if the business is successful.
- Available to companies that are too young for an IPO: Companies often need a proven track record to sell shares publicly or access other types of investment. Venture capital helps companies that aren’t ready for the next level of funding resources.
- Access to business expertise: Venture capital firms are often filled with successful entrepreneurs who can share their business expertise with the companies they fund.
- High risk for investors: Because the companies that receive venture capital funding have little to no track record, investors take on a substantial risk of losing their money.
- Loss of partial equity: When businesses take on venture capital funding, they usually give up some equity. Depending on the situation, they may sacrifice 50% or more ownership.
- Loss of control and decision-making power: When companies take on investors’ money, they often also must accept those investors’ opinions when making business decisions.
What Individual Investors Should Know About Venture Capital
Most individual investors will never participate in venture capital. Venture capitalists are usually institutions and affluent individuals. The combination of the high cost of entry and the high risk means it's not an appropriate investment for most.
Even if you never participate in venture capital, most of us are affected by it somehow.
Venture capital plays an increasingly important role in the U.S. economy. And many of the companies you likely come in contact with regularly have benefited from venture capital. Well-known companies like Airbnb, Instacart, and Uber got their start thanks to venture capital.
And even if you aren’t one of the high-net-worth individuals whom venture capital typically attracts, there may be a place for you. Fintech companies have made it possible for anyone to participate by pooling the money of many smaller individual investors and channeling it into startups.
- Venture capital is a form of business financing in which institutions and wealthy individuals invest in startup and early-stage companies.
- Venture capital beneficiary companies are often too new to obtain funding through an IPO or other traditional means.
- Alternatives to venture capital include private equity, angel investors, and crowdfunding.
- Venture capital presents a high potential reward for investors in exchange for a significant level of risk.
- Individual investors may have the opportunity to participate in venture capital through fintech companies and micro venture capital opportunities.