Table of Contents
What is venture capital?
Can anyone invest in venture capital?
What are the risks when investing in venture capital?
Oct 18, 2022
6 min read
Venture Capital’s equity yields huge paydays if the startup is sold, goes public, or if the company fails. Other possible risks include illiquidity and less transparency.
Every investment opportunity is a balance of risk and reward. Playing it safer means less chance of huge losses, but also limited upside. High-risk investments can mean there’s a chance to lose it all—or make big gains.
Venture capital falls squarely into the second category. Venture capitalists could reap huge payouts if the company they invest in succeeds and is sold or goes public. Or, as is the case more often than not, the company never becomes profitable or even fails, resulting in a complete loss.
, or “VC” for short, is an umbrella term for funding provided by investment firms and individual investors to young, privately held companies that they believe have attractive growth potential. Venture capital funds are usually raised in rounds (after angel investors provide seed money in the earliest stages of the company), from Series A to Series D and sometimes beyond.
Startups with VC backing enjoy the benefit of raising funds without having to take out expensive bank loans, putting that capital to work to expand. In exchange for funding, startups usually fork over equity, or partial ownership, in the company to the VC firms. But there is no guarantee that a company in its early stages will profit—or even survive—over the long term.
In the event that the startup is sold or goes public in an IPO (known as an “exit”), the VC can liquidate their ownership, likely selling it for much more than they paid for it when they made the investment. If neither of those happens—and in many cases they don’t— the venture capital firms’ investments might wind up being worthless. High risk, high potential reward.
Not everyone is allowed to make venture-capital style investments. That’s because shares in privately held companies are unregistered securities—meaning they aren’t registered with the Securities and Exchange Commission (SEC).
Companies register with the SEC when they have an initial public offering (IPO) and get listed on a stock exchange. Once that happens, the company can raise money by selling shares to the general public. Before they go public, they aren’t registered, and the SEC limits the buying of unregistered securities to “accredited investors.” These are individuals or entities that are either wealthy or financially knowledgeable, based on specific criteria set by the Securities and Exchange Commission.
Accredited investors have several unique investing opportunities available to them that may not be in reach for other investors — including startups, private equity funds, peer-to-peer (P2P) lending platforms, real estate crowdfunding, initial coin offerings (ICOs), and more.
The SEC established accredited investor requirements in 1933 to make sure would-be investors really do have the capital to invest, and/or that they understand what it means to invest in ventures that are in their early stages. But the definition of who qualifies as one has evolved over the decades. In August 2020, for example, the SEC expanded the definition to include individuals who can qualify based on their professional knowledge.
An individual may qualify to be an accredited investor based on one of a few different factors. They must either:
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over the past two years and expect to earn at least that amount in the current year; people with spouses (or spouse equivalents) can also qualify if their combined income is more than $300,000
, either individually or combined with a spouse or spouse equivalent
by obtaining and keeping in good standing one of three professional certifications, all of which require passing exams: a representative license (Series 7), an investment advisor representative license (Series 65), or a private securities offerings representative license (Series 82)
Certain types of entities also qualify as accredited investors. These include:
such as banks, insurers, or registered investment companies.
, including VC firms, limited liability companies (LLCs), Indian tribes, family offices, funds, and more. (Note, however, that entities may not qualify if they are created with the sole aim of making an investment or investments that are limited to accredited investors).
, or plans for which a bank, insurer, or registered investment advisor makes the investment decisions.
Investors who are not accredited can still invest in startups, however, albeit in a different way. Crowdfunding is a relatively new method that companies can leverage to raise capital from founders’ personal, professional, and social networks. Contributors may simply donate money to help the business grow with no expectation of anything in return, or they may give funds in exchange for a “reward”—something as little as a thank-you note or a larger reward like discounted goods or services from the company.
Non-accredited donors can also give money in exchange for equity, though the SEC limits both how much companies can raise through crowdfunding and how much non-accredited investors can invest across all crowdfunding platforms. Funds may also be pledged as a loan that the company repays, with interest, by a set deadline.
These unique investment opportunities do come with potential risks, including:
VC funding has backed some of the most innovative U.S. companies, including tech behemoths Apple and Amazon. But for every smash success, there are many less-happy endings: The National Venture Capital Association estimates that 25% to 30% of VC investments fail, while another 30% to 40% return only their investors’ original capital with no profit. Some estimates put the failure rates much higher. This is arguably the biggest factor looming over a VC’s decision about investing in companies, and if so, which ones?
Unlike investors in traditional financial securities that trade in public markets, VCs can’t just pull out their cash whenever they want. On the contrary: It’s a long-term, highly illiquid investment. VCs may end up waiting years to get back even their original investment–if that. If a startup goes bust, that investment could vanish.
While startups typically share some financial data to persuade VCs to invest, they’re still early-stage and privately held. So VCs won’t have the type of information that they would get from publicly traded companies, including the mandated quarterly financial reports, analyst research notes, or investor days. It can also be difficult to benchmark a startup’s performance against others in the field, particularly if it’s a niche company or part of an emerging industry.
Venture capitalism is an example of a high-risk, high-reward capital investment: In exchange for funding an early-stage company, venture capitalists usually receive an equity stake in their portfolio companies. VCs, whether individuals or entities, must be accredited investors as defined by SEC guidelines, which include qualifications such as net worth and expertise.
VCs’ equity stakes can yield huge paydays if the startup is sold to another company or goes public on the stock market—or the investment could end up being worth nothing if the company fails. Other risks of this type of investment include illiquidity, less transparency, and VC firms’ high management and performance fees.
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