One of the catalysts for America’s postwar economic dominance has been the breakneck growth of innovative companies, many of them backed by the venture capital industry.
VC firms have financed such trail-blazing businesses as Microsoft, Apple, Amazon, Netflix, and Google, showcasing the industry’s ability to drive ingenuity and growth.
Along the way, they created hundreds of thousands of jobs, while building products and services that have improved the day-to-day lives of billions of people around the world.
How does venture capital funding work?
The term venture capital refers to the investment firms that finance young, privately held companies with attractive growth prospects. Specialized partnerships, managed by venture capital firms, furnish the funding in exchange for partial ownership through equity or equity-like investments in the start-ups.
Prominent VC firms such as Silver Lake Partners, Warburg Pincus, Sequoia Capital, Kleiner Perkins, and Andreessen Horowitz may also provide technological, financial, and management advice to the start-ups they invest in.
The VCs and their limited partners typically profit—a process known as “exiting” in the VC industry—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 an initial public offering, or IPO.
For young companies, the appeal of venture capital is that the cash doesn’t have to be repaid, at least in the conventional sense. Rather, companies pay for funding with equity, an ownership share in the company, so it gets paid off through the exit process—that is, if there is one.
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 put in money in previous financing rounds.
What are all the rounds that make up venture capital funding?
Traditionally, VC investors were typically absent from the very earliest phases of start-up development, preferring to jump in only once the business got off the ground. Today, VC firms may be involved in a company from day one. By the time a company goes public or is sold, between 25% and 50% percent of a start-up will be owned by venture capital investors.
The VC industry has different ways of evaluating these new enterprises—and their corresponding sources of funding—but some divide it into six stages, or “rounds.” The amount raised during each round varies depending on the financing needs and the start-up’s overall valuation.
The classes of private stock issued in the various funding rounds are also not uniform. “Each round is priced independently, with different characteristics,” says Titan senior investment strategist John Bottcher.
Pre-seed and seed stage
In this stage the founders’ are honing their idea for a viable business, performing market research, soliciting advice from industry experts, and working out ownership details and other legal matters. They might put in their own money as well as what capital they can drum up from friends and family. VC firms use scouts to identify worthy start-ups that are still small enough to fly under the radar.
Then, founders develop a pitch book that outlines the business plan—critical for attracting capital—and begin to ramp up product development. The founders may crowd-source funds, using online platforms. Another source of capital is angel investors, who specialize in this high-risk, high-payoff stage, spreading their bets across multiple prospects. Several mainstream VC firms, including Andreesen Horowitz, have started funds dedicated to seed stage, or even pre-seed, companies.
Usually, pre-seed and seed-stage funding total less than $5 million. Photosharing app Instagram, for example, raised $500,000 in its 2010 seed round. Seed funding round sizes have risen over time. In 2016, women’s healthcare platform Maven raised $2.3 million in seed funding. In late 2020, Upway, a French startup building a marketplace for refurbished e-bikes, raised a $5.7 million seed round.
At this stage, the enterprise is stepping up advertising and marketing, increasingly selling products or services and generating revenue, though not necessarily any profit. The workforce expands. At this stage, management needs to articulate long-term strategies to investors. Mainstream venture capital firms may examine the company’s books and prospects—and those who believe in the founders and vision for the company may invest in a big way.
In 2019, the average series A size was $13 million—but the range can vary. Maven, for example, raised $10.8 million in series A funding in 2017, whereas HR platform Rippling raised $45 million in 2019. Web development platform Webflow raised a staggering $72 million in their 2019 Series A.
At this point, having demonstrated sufficient demand and management skills, the start-up is expanding its production or services. This is when the business must prove its ability to scale.
Mainstream venture capitalists are investing money at this point along with a coterie of so-called family offices that manage the assets of wealthy individuals and corporations with VC operations. In 2021, the average size of series B rounds was $45 million—a substantial increase over previous years.
The venture company has established a record of growth and market relevance. It may further expand product or service offerings, push into new markets and perhaps make opportunistic acquisitions. Late stage venture capitalists are often big investors in this round, and they may be joined by a range of more mainstream players, from hedge funds to banks to private equity firms.
In 2020, the median series C round size was $52 million, but some startups certainly exceed this. Brand aggregator Heyday, for example, raised a $555 million series C in 2021, after raising a $70 million series B six months prior.
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. Crypto exchange Coinbase, for example, raised a $100 million series D to increase their customer service capacity and make a strategic acquisition.
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 is an IPO?
The IPO is really the culmination of the venture capital process, allowing entrepreneurs to cash out some of their holdings, and the VC firms and their limited partners to exit their investments, harvesting profits or recording losses in the process.
It’s an arduous affair, requiring the approval of the Securities and Exchange Commission (SEC) and the stock exchange where the shares will trade, such as the Nasdaq or New York Stock Exchange.
The start-up generally solicits proposals from Wall Street firms, such as Goldman Sachs, Morgan Stanley, or JPMorgan Chase, to manage or “underwrite” the offering. When one or, more likely, several banks are selected, the start-up’s management sets about drafting an S-1 registration statement which is filed with the SEC and made available to the public. The S-1 includes a preliminary prospectus, or “red herring,” that lays out the new company’s history, business model, current and past financial statements and risks.
In drafting the document, which is subject to multiple revisions, the company works with the underwriting team, as well as lawyers, accountants, and auditors to craft a document that will pass muster with the SEC—and help sell the stock offering to investors.
From there it’s on to marketing. The investment bankers canvas institutions and other wealthy investors, seeking to drum up demand for the start-up’s shares, often by introducing them to management in person during visits to various cities in so-called roadshows.
Once a date is selected for the IPO, the bankers establish a price range at which the company’s shares will be sold. They must balance the company’s eagerness for a high price with the demand they gauge from retail and institutional investors. A definitive price is announced the night before the shares begin trading.
Typically, the underwriters retain the right to buy an additional 15% of the company’s shares at the IPO price—a “greenshoe” in industry parlance. That incentivizes them to goose the new issue’s share price, although the stock may or may not shoot up on an opening day. Insiders are generally required to hold onto their public shares for a lock-up period of 90 to 180 days.
Other ways to exit
If the IPO process sounds complicated, that’s because it is. And that’s why plenty of companies opt to sell to corporate buyers instead. It too can be challenging, but there’s generally just one potential buyer to please instead of many.
Alternatively, the start-up may also opt for a direct listing, in which shares are simply listed on an exchange, after SEC approval. Without the support of underwriters and their orchestration of institutional demand, however, that may result in price weakness. Well-known startups such as Spotify and Slack have gone public via direct listings.
Another course of action is a dutch auction, in which prospective buyers submit bids for specific share amounts and the company fulfills the offers with the highest prices.
The bottom line
Venture capital provides fuel for innovative companies, generating high-paying jobs as well as vast profits and serving as an engine for U.S. economic growth. Many of America’s most prominent companies got early support from VC firms.