What is Venture Capital?
Building on our last two fundraising posts.
TLDR:
Venture capital invests in high-risk, high-growth companies with the hope of a high return.
Venture capital funds are intermediaries, meaning they invest other people’s money into companies. A VC’s job is to make money for their investors in ten years or less.
Venture capital isn’t right for every company or founder. VC works for high-growth, high-margin businesses that can scale quickly in a large market in the next decade.
As a founder, it’s important to know and use the different fundraising tools at your disposal.
What is Venture Capital?
Venture capital funds invest in high-growth companies, typically early in a company’s lifetime. While angel investors invest in high-growth companies directly, venture capital funds act as intermediaries that invest other people’s money in these companies.
Depending on who you ask, venture capital has either been around since the Dutch whaling industry of the 17th and 18th centuries or originated in the 1940s in the U.S. Regardless, the fundamental idea of people with money investing in high-risk, high-return ideas has existed for centuries.
How Does Venture Capital Work?
Venture capital (VC) partners, known as “General Partners” (GPs), raise money from individuals and institutions with capital to invest, such as pension funds, high-net-worth individuals, and university endowments (called “Limited Partners” or LPs). GPs are responsible for making money for these LPs. Unlike public markets, like U.S. stock exchanges, venture capital is only available to accredited investors.
The VC business model is straightforward in theory but challenging to execute well. Venture capital firms typically charge investors two types of fees:
Management Fee: Usually 2% of the total capital raised, used to cover operational expenses, including salaries and running the fund.
Performance Fee: Known as “carried interest,” this is typically 20% of the profits earned when the firm makes money for its investors.
Example:
Let’s say a VC fund raises $10 million. The firm charges a 2% management fee, which equals $200,000 annually, to cover operational expenses. The remaining $10 million is invested in startups over 2-3 years. After 10 years, the fund’s investments return $30 million. Here’s how the distribution works:
The first $10 million goes back to the LPs.
Of the $20 million profit, the GPs take 20% ($4 million) as carried interest.
The LPs receive the remaining $16 million, making their total return $26 million (2.6x the initial investment).
Portfolio Dynamics:
For every 10 startups a VC invests in:
3 will fail, returning $0 to investors.
3-4 will succeed modestly, returning the original investment.
1-2 will be phenomenally successful, going public or being acquired and returning 10x or more of the initial investment.
These 1-2 breakout successes often generate the majority of returns for the entire fund. Ideally, a successful VC fund returns 3-5x the invested capital within 10 years. However, only the top 25% of VC funds typically achieve this.
VCs need to invest in companies operating in large, fast-growing markets to achieve these returns. Consequently, VCs often focus on technology businesses and founders with deep technical or market expertise.
Why Does Venture Capital Matter?
Venture capital has been a powerful tool for driving innovation. Technologies like semiconductors, personal computers, smartphones, social media, and artificial intelligence have all benefited from VC funding. These advancements have impacted the world, often for the better.
However, venture capital isn’t a fit for every business. VC works best for high-growth, high-margin businesses that can scale quickly. Many technology companies meet these criteria. That said, like the high-risk startups they invest in, approximately 50% of VC funds fail to return even 100% of the capital invested. VC’s also take an active role in the businesses they invest in. They often sit on the board of directors and may even have the authority to hire or fire the CEO. While this oversight can provide valuable guidance, some founders may find it intrusive.
Women and people of color have historically been left out of venture capital funding. in 2023, women received less than 2% of all VC funding, black founders received 1%, and Latino founders 1.5%. While organizations like All Raise and others are working to change this, the bias is hard to ignore.
As a founder, it’s crucial to understand the various fundraising tools available so you can choose what’s best for your business.
Additional Resources
Photo by Shifaaz shamoon on Unsplash