Venture capital (VC) is a subset of private equity or private financing, specifically to invest in startups intending to drive innovation and economic growth.
Venture capital funds have become an increasingly popular and necessary source of financing for startup companies, as these firms often can't access more traditional funding sources like public markets, banks, or debt equity. This is due primarily to the fact that such businesses have higher risk profiles than conventional companies. This resulted in a massively growing venture capital industry - $164 billion have been invested in startups since 2006.
Startups often search for venture capital funding to finance their projects, increase their presence in specific markets, and accelerate their growth rate. In addition to capital, venture capitalists can provide great value for startups by introducing them to potential partners, customers, or suppliers. As venture capitalists tend to invest in various industries and business models, they often bring a wide range of expertise that can help early-stage companies succeed.
Private Equity vs. Venture Capital
One core distinction between venture capital funds and traditional private equity is that venture capitalists focus predominantly on early and emerging companies. In contrast, private equity investors typically target more well-established businesses with a proven record of success.
This difference in investment strategy reflects the varying skills required by venture capitalists and private equity investors, namely, the ability of the former group to accurately predict which firms will succeed before it is easily identifiable.
While private equity originated around the 19th century, venture capital is more recent, only developing after World War II. Georges Doriot, a former business professor at Harvard Business School, is known to be the "Father" of venture capital. In 1946 he raised a $3.5 million fund to invest in companies that commercialized technology developed for World War II.
He is notorious for turning a $200,000 investment in a company using X-rays for cancer treatment into $1.8 million during an initial public offering exit in 1955.
The venture capital industry received a helping hand from regulators. Here are a few government initiatives that helped boost the industry:
In 1958, the Small Business Investment Act (SBIC) provided tax breaks to investors.
In 1978, the Revenue Act was amended to reduce the capital gains tax from 49% to 28%
In 1979, an alteration to the Employee Retirement Income Security Act allowed pension funds to invest up to 10% of their assets in small or new businesses, aka startups.
In 1981, the capital gains tax was reduced again to 20%
In 2012, the JOBS act was passed in hopes of jumpstarting funding for small businesses.
In 2016, it enabled everyday people to invest capital in startups.
Nowadays, venture capital firms usually raise funds from larger institutions like family offices, pension funds, or other wealth funds. Some of the most popular venture capital firms include Andreessen Horowitz, Y Combinator, Sequoia, and Kleiner Perkins.
Types of Investors
Several different types of venture capital investors are differentiated by stage and industry. Most venture capital firms and investors have a unique thesis and, depending on their preference, look for specific qualifications in companies they invest in.
Venture capital and angel investors perform the same function, with one key difference. Angel investors almost always invest their own money, while venture capital investors usually invest other people's money, they are categorized as institutional investors. Angel investors typically invest smaller dollar amounts compared to more extensive checks from venture capital investors.
How Does It Work?
The typical investment process starts with deal sourcing, where the venture capital firm meets with the various startups and narrows it down to the ones they are most interested in or consider the best fit. The next step is usually due diligence, which ranges in requirements per firm and stage. If a startup passes this process, terms are negotiated before the firm writes a check, usually in exchange for startup equity. The investor exits when a company is acquired merges with a larger company, or goes through an initial public offering process and hopefully receives a return on their investment.
These investments are risky by nature and generally occur before the startup company has any traction (revenues, clients, users, etc.). This is why venture capital investing can be challenging but highly rewarding (based on past performance compared to traditional capital markets). The logic behind VC is that a few highly successful companies can compensate for the losses. Therefore, venture capitalists usually take a longer-term approach and diversify across sectors, stages, and regions.
Since venture capital investments can be risky, diversifying your investment portfolio is the most well-adopted strategy to manage risk. aVenture will be able to offer a similar approach to investors by giving them access to a diversified set of venture capital funds and startup companies. To learn more about how you can start to invest in venture capital, visit our website.