Venture Capital: Definition and How It Works

The roots of venture capital in the United States go back at least to the early decades of the 19th and early 20th centuries, when J.P. Morgan and storied families like the Vanderbilts, Rockefellers, and Whitneys were laying out their own capital to finance growing railroads, steel mills, and other industrial enterprises.

The founding of the American Research and Development Corp. (ARDC) by three Boston-area academics and industrialists in 1946 ushered in today’s venture capital structure, raising money for the first time from pension funds, endowments, and other institutional investors. Predicated upon the notion that technologies developed during World War II could be harnessed for commercial gain, ARDC provided capital for Digital Equipment Corp. in 1957, earning it an annualized return of more than 100% when the pioneering computer company went public in 1968.

Since then, venture capital has financed such technological juggernauts as Hewlett-Packard, Microsoft, Apple, Amazon, and Facebook, showcasing the industry’s ability to drive innovation and growth, and helping to make the U.S. the world’s most dynamic economy.

What is venture capital?

Venture capital is an umbrella term for the investment firms that finance young, privately held companies with attractive growth prospects. Specialized partnerships, managed by venture capital firms, furnish the capital in exchange for equity or equity-like investments in the start-ups.

“The VC uses capital to invest in potential high-growth companies,” says Titan senior investment strategist John Bottcher. “There is a high-risk, high-return reward to whoever is providing the capital.”

VC firms such as Silver Lake Partners, Warburg Pincus, Sequoia Capital, Kleiner Perkins, and Andreessen Horowitz also frequently provide technological, financial, and management advice to the start-ups they invest in.

The VCs and their limited partners typically harvest profits from their investment in one of two ways: either when the start-up is acquired by a bigger, established company or by selling shares in the company to the public via an initial public offering, or IPO.

For young companies, the lure of venture capital is that it doesn’t have to be repaid, at least in the conventional sense. VCs receive equity, an ownership share in the company, in exchange for cash, so the investment is paid back only when the start-up experiences a liquidity event—either a sale to another company or an IPO.

On the other hand, each new round of funding—while providing needed operating funds for growth—dilutes the founders’ ownership position as well as that of earlier investors who participated in previous financing rounds.

Venture capital funding rounds

Traditionally, venture capital investors were absent from the very earliest phases of a start-up’s lifecycle, jumping in once the business got off the ground—though there are some exceptions. Experts have different ways of parsing the evolution of these young enterprises—and their corresponding sources of funding—but many divide it into the following stages:  

• Pre-seed and seed

  : In the earliest stages of developing a company, founders may contribute their own funds, crowd-source funds, or turn to angel investors, who specialize in high-risk, high-payoff deals. Recently, mainstream venture capital firms started establishing separate investment funds dedicated to furnishing capital for these seed and pre-seed phases of start-up development.

• Series A

  : The Series A funding round is the first stage where mainstream venture capital firms inject money into the start-up after examining the company’s books and performing due diligence on the company’s business plan and founders.  

• Series B

  : At this point, the start-up is expanding and raises more capital in a Series B funding round. The young company is demonstrating management skill and that there is demand for its products or services.

• Series C

  : Once a start-up has a track record of growth, late-stage venture capitalists will show interest in a Series C funding round. They may be joined by more mainstream players, from hedge funds to banks to private equity firms. 

• Series D and beyond:

  Not all companies raise a series D, but some may need additional funding to get them to a liquidity event. A start-up may want to invest in more growth to increase its valuation before going public; or, on the flip side, they may have underperformed after their series C and need to take on additional funding at a lower valuation. This latter scenario is known as a ‘down round.’ Some companies raise series E, F, and beyond, as well.

What are the different types of venture capital firms?

Venture capital firms vary enormously in terms of their investment strategy and approach. Below are some of following:

• Geography

  : Certain firms focus on specific geographic areas, like the Southeast or Midwest U.S., where there may be less competition than in other regions. 

• Sectors

  : Some VCs specialize in particular sectors, such as biotechnology or sports and entertainment because they have specialized industry knowledge.

• Company age

  : Some firms specialize in investing at the seed stage—a particularly high risk-high reward phase of the venture cycle—while others are late-stage investors and prefer to pony up in the C round of financing or mezzanine stage.

How do VCs find start-ups to invest in?

Venture capital firms use a variety of methods to find promising founders and companies to invest in, including: 

• Conferences:

  Venture-focused conferences offer VCs the opportunity to meet and greet entrepreneurs.  

• Introductions:

  Investment firms and banks can serve as matchmakers between VCs and entrepreneurs seeking funding, either individually or at sponsored events.

• Scout programs:

  In the past decade, VC firms have established scout programs to help them identify worthy start-ups that have been flying under the radar. The scouts are often managers at the fund, and they stand to gain a portion of the profits from the investment.‍

• Past founders:

  Lastly, start-up founders often are serial entrepreneurs who have launched, funded, and sold businesses before. So they are already familiar with various venture capital firms, and can tap a network of often-eager investors. A venture capitalist will readily answer the call from an entrepreneur who has made the firm and its limited partner's money in the past.

What is the difference between venture capital and traditional bank debt?

Entrepreneurs often consider the merits of venture capital versus traditional bank financing. The first involves giving away equity, and the second means taking on debt. Though start-ups might opt for a blend of the two, there are pros and cons to each approach.

• Uncertainty vs certainty:

  With venture capital, entrepreneurs really aren’t sure how much they are paying for funding because the “price” is ultimately determined by what a company’s shares fetch somewhere down the road. With bank debt, which is typically in the form of term loans and lines of credit, rates and terms are clearly specified at the outset. 

• Profit and loss:

  Giving up a chunk of equity, regardless of how much a venture capitalist pays for it, doesn’t necessarily directly impact a young company’s profit and loss statement. By contrast, bank lines of credit and loans require interest payments, and recurring expenses that may impair profitability and reduce the money available for daily operations or capital expenses. 

• Credit histories:

  Seeking bank credit will likely mean intensive scrutiny of both personal and business records, and rigorous credit checks that may be problematic for entrepreneurs running a money-losing company. Banks may even apply non-negotiable minimum credit scores as lending hurdles. Venture capitalists, by contrast, are likely to be more forgiving of credit blemishes, especially if they were incurred at previous start-ups, which they are likely to consider a plus.

• Flexibility:

  Business loans provide more flexibility to the borrower because banks typically aren’t too concerned with how the proceeds are spent as long as the company pays its interest on time. VCs, on the other hand, may seek board representation and seek to influence how proceeds are spent.

How is venture capital regulated?

Venture capital is a lightly policed industry, especially compared to the publicly traded markets. However, that doesn’t mean anything goes.

The primary regulator of VCs is the Securities and Exchange Commission (SEC), which also keeps an eye on hedge funds and leveraged buyout firms. Venture capital firms must register with the agency if they have more than $150 million in assets.

Since much of the money flowing into venture capital funds come via banks serving as conduits for institutional investors, the funds are indirectly subject to anti-money laundering provisions of the Bank Secrecy Act. Firms are also subject to “know your customer” rules included in the USA PATRIOT Act.

At one point, VC firms were forbidden to advertise or solicit the public. In 2020, that was modified to allow them to advertise that they are raising money. Investors with less than $1 million in liquid assets are generally barred from investing directly in many private investment funds, including those run by venture-capital firms. 

How often are venture-capital investments successful?

One of the most critical metrics for gauging venture capital is also one of the most elusive: How many VC investments, on a percentage basis, are successful? Some VC firms have recognized huge returns from the likes of Apple, Intel, and Amazon. However, VC return figures must also incorporate the substantial losses incurred on the majority of their investments.

The National Venture Capital Association estimates that 25% to 30% of investments fail, while another 30% to 40% only return their investors’ original capital. Another estimate puts the failure rate at 75%.

Research firmCambridge Associates calculates that U.S. venture capital returns averaged 10.9% annualized for the 20-year span ended Sept. 30, 2021. That is slightly more than the roughly 10% average annual historical return of the Standard & Poor’s 500 Index, which is heavily influenced by the performance of big tech companies—many of which were backed early on by VCs. 

The bottom line

The venture-capital industry has backed some of the most innovative companies in the world, generating an enormous number of high-paying jobs and vast profits that have boosted U.S. economic growth. Some of the world’s biggest and most visible companies, such as Apple, Intel and Amazon, all got support early on from VC firms.  A VC firm can play a seminal role—from inception to adolescence to a sale or IPO— in the life cycle of a startup. Although a handful of investments pay off and yield enormous returns, most new companies fail. Those failures produce losses for VC firms, offsetting much of their investment gains.