What Is Venture Capital?

Venture capital is a type of private equity that investors buy in startup companies and small businesses. Venture capital investors will buy equity in small, new companies that they think show a high potential for growth. In the best-case scenario, the startup company gets much-needed capital at a critical stage in its development, and the investors sees a high return on their risky investment.

Venture capital investing is relatively high-risk, because it means investing in a company that doesn’t yet have a track record of success. On the other hand, venture capital investments can be quite lucrative if a company becomes a success. Because of this, venture capital investors tend to be wealthy — either successful investors with a high net worth, or investment firms — with an appetite for risk and the funds to absorb potential losses.

A typical venture capital deal involves a company ceding a large portion of ownership to a private investor (or a group of investors). This is generally done via independent limited partnerships. Occasionally, venture capital investors will provide more than just investment capital; they may also share their expertise with the companies they invest in or act as business mentors.

What does venture capital do for businesses?

The roots of venture capital investing can be traced to the 1940s. However, this type of capital was a relatively niche part of the business landscape until the dot com boom of the mid 1990s. At this time, venture capital investments helped to launch many of the most successful companies in the world — including Amazon.

Today, venture capital is an important financing option for startups and other new businesses. It is an increasingly common way for new businesses to access capital in the first few years of existence, before they have access to more “traditional” financing options such as bank loans.

Data from the NVCA and PitchBook indicate that venture capital investing is now more popular than ever. A record $330 billion was invested in this way in 2021, more than double the total for 2020 ($164 billion), which was also a record at the time. In addition, deals are getting larger and larger, with investments of $100 million or more also becoming increasingly common.

Types of venture capital

By definition, all venture capital investments are focused on companies that are at an early stage of development. However, the first few years of a company’s growth can be further divided into a number of stages. Venture capital investment received at each stage goes by a different name:

Pre-seed. This is the earliest stage of a company’s development, when the founder tries to turn a promising idea into a coherent business plan. Venture capital funding can be accessed at this stage via business accelerator programs.

Seed funding. The next stage is for a company to launch its first product. Since they will have no revenue streams at this point, and may find it very difficult to obtain traditional financing, many companies turn to venture capitalists to fund their product launch.
Early-Stage funding. If a company has successfully launched a product, and this has gone well, it may seek venture capital investment in order to scale its business model. This is often done via a series of funding rounds: Series A, Series B, and so on.

In general, the earlier an investment in a company, the riskier it is, but the greater the rewards if an investor picks a company that becomes successful.

Private equity, angel investors and venture capital differences

Venture capital funding is often confused with two other, similar types of funding: private equity and “angel” investors. There are some key differences between these types of investment.

The difference between private equity and venture capital

Private equity investors tend to focus on large, established firms, and they tend to try to buy 100% ownership of a firm. In contrast, venture capital investors are more likely to invest in a variety of companies to spread their risk, and they generally only buy a minority stake in them (less than 50%).

The difference between angel investors and venture capital

Angel investors are generally high-net-worth individuals who are willing to provide a risky investment to a firm that they think has potential. They are a type of venture capital investor, but not the only type. Venture capital can also be provided by investment firms, or through associations of individual investors working together.

An example of venture capital

Many of the largest companies in the world today — and especially tech companies — started out their development with the help of venture capital.

For example, in 1999 Google received a significant boost to its working capital when Kleiner Perkins Caufield & Byers and Sequoia Capital together invested $25 million in the then-new firm.

Sequoia Capital was also instrumental in providing venture capital to WhatsApp in its early years. In 2011, the investment firm invested $8 million, and then went on to invest more than $60 million over the following decade. Then, when WhatsApp was acquired by Facebook for $16 billion, the company received a huge return on this investment.

Sequoia Capital is, in fact, one of the largest and most successful venture capital firms today, and has invested heavily (and successfully) in many tech startups at an early stage of their development. These companies include some of the largest in the world: Apple, Google, Zoom, and Instagram.

The pros and cons of venture capital

Venture capital investing is a crucial part of the contemporary business landscape, but it does carry risks for both investors and the companies they invest in.

Advantages of venture capital

The main advantage of venture capital for new companies and startups is that this can provide access to much-needed capital before other sources are available. In order to take out a bank loan, a company will normally need to show cash flow or assets – neither of which it will have at the very earliest stages of its existence.

Some venture capital firms also provide mentoring or networking for the firms they invest in. This can help a new company build a rigorous business plan, or help them to acquire talent.

For investors, the attraction of venture capital investments is the high returns that can be generated. If an investment firms invests early in a company that becomes the next Amazon or Facebook, they can potentially make many billions of dollars of profit.

Disadvantages of venture capital

For startups and new businesses, the main drawback of venture capital funding is that venture capital investors generally demand a large share of company equity in exchange for their investment. Depending on how large the company eventually grows, this could mean that founders have given away equity worth many times more than the original investment.

Similarly, because ownership of company equity generally confers voting rights on its holders, the founders of a company can find themselves losing control of it. If venture capital investors own a large proportion of a firm, they may be able to control its decisions.

The main disadvantage of venture capital investments for investors is simply that they are very risky. Investing in a company with no proven track record, and often even without a viable product to sell, is a very high-risk strategy. This is why venture capital investment is generally restricted to high net worth individuals and specialized investment firms.

Venture capital key takeaways

Venture capital is a form of private equity and financing that investors provide to new businesses and startups that they think show a good potential for growth. Venture capital investors are generally either high-net-worth individuals or specialized investment firms.

For companies, venture capital can provide a much-needed source of finance at a critical, early stage of development when other sources of capital are hard to access. In exchange, however, a venture capital investor will generally demand a relatively high amount of equity in the firm.