What is venture capital: A beginners guide to investing in venture capital (2024)

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  • Venture capital (VC) is a type of private equity and financing for startups believed to have the potential for long-term growth.
  • Venture capitalists fund startups in exchange for ownership stake in the company.
  • Accredited investors can invest in venture capital through VC firms, which operate and manage VC funds.

What is venture capital: A beginners guide to investing in venture capital (1)

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Venture capital investments are the epitome of the bigger the risk, the higher the rewards. But what does it mean to be a venture capitalist? How does venture capital actually work? And how can you invest?

Venture capital funding is an important economic stimulant that helps give new industries and ideas the chance to thrive. In turn, this can generate new job growth, create new business models, and encourage innovation in the current market.

Here's everything you need to know about venture capital, VC funds, and more.

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What is venture capital?

Venture capital (VC) is a type of private equity and financing for entrepreneurs, and startups. In exchange for preferred equity in the startup, investors (aka venture capitalists) support startups believed to have the potential for long-term growth with the hope of getting outsized returns.

Matt Malone, the head of investment management at Opto Investments, explains, "These companies may not have a proven product or revenue stream, so traditional funding sources are not an option for them. Venture capitalists are willing to assume and manage the risks associated with startups."

VC is an alternative investment, like hedge funds or managed futures, often only available to certain high-net-worth investors and institutions. Keep in mind that investing in venture capital comes with significant risk.

Venture capitalists are typically accredited and wealthy individuals, financial institutions, or investment banks that are able to provide significant capital funding, managerial guidance, or technological expertise to early-stage companies and startups.

Before earning any revenue, new businesses and early-stage companies can collect funding and expertise from these venture capitalists. Unlike a bank loan, the capital given to these startups isn't required to be paid back. This allows startups to get a jumpstart toward establishing a successful business. But investors may lose most, if not all, of their investments

This probability of loss is generally anticipated by venture capitalists who are aware that they are likely to lose most of their money. Although the chance of success is slim and a company may take years to become profitable, venture capitalists can't seem to resist the potential of discovering a "unicorn."

What are venture capital funds?

Venture capital funds are pooled funds from investors, called limited partners (LPs), looking to get equity from startups and early-stage companies with long-term growth potential. Instead of investing in a single startup, venture capital funds invest in multiple companies with a time horizon between six and 10 years.

Venture capital funds tend to follow a single idea that targets a section of the market or a certain stage of investment. Depending on the maturity of the business, venture capital investments are either considered seed capital, early-stage capital, or expansion-stage financing.

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Managers of venture capital funds are called general partners (GP) and are in charge of selecting investments, raising capital from outside investors, and performing accounting and legal operations.

"The GP develops the fund's investment strategy. This includes the industries and types of companies that they will invest in, such as technology, consumer goods, etc. The strategy may define whether the investments are targeting seed, early-, mid-, or late-stage companies," says Malone.

Typically, limited partners have to be accredited investors (someone with a net worth of at least $1 million). The minimum needed to invest in a venture capital fund varies by fund. Minimums can range, for example, anywhere from $1,000 to $500,000 or higher.

What is a venture capital firm?

Venture capital firms are companies that raise funds and manage and operate venture capital funds in exchange for partial ownership of the startup company (generally under 50% ownership stake). In simple terms, venture capital firms are the middlemen between startups and venture capitalists. New and early-stage companies go to VC firms for access to capital funds, managerial expertise, and LPs.

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The goal of venture capital firms is to sell the stake in an emerging company or exit the investment through an initial public offering (IPO). VC firms take a chunk of the VC fund's profit, often between 20% and 50%. They also make money from management fees and performance fees.

"VC firms get paid to provide their expertise in identifying and evaluating potentially promising startups. They are looking for innovative ideas that solve a real problem and capable founders who can make those ideas a reality," Says Malone. "These funds may vary in sizes from a few million to several billion dollars, depending on the strategy."

A popular fee structure for venture capital funds is the two and twenty model, which is when a VC firm charges a 2% assets under management (AUM) fee and a 20% of the profits' performance fee.

Some of the top venture capital firms are:

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  • Sequoia Capital
  • Andreessen Horowitz
  • Accel
  • Kleiner Perkins
  • Bessemer Venture
  • Intel Capital
  • New Enterprise Associates

How venture capital works

Startups seek out venture capital firms in order to obtain funding and access to resources. Startups begin by submitting a thorough business plan. Business plans should include a business model, operation history, product plans, and other essential information regarding the proposed business idea.

VC firms will then conduct an extensive analysis of the proposed plan (referred to as due diligence) to determine the quality of the plan and whether or not it shows growth potential. VC firms may also examine personal information, such as your professional experience, educational background, and other relevant information

If the business plan is approved, VC firms offer startups funding in exchange for equity in the business. They may also become more hands-on.

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"Once they invest, the fund managers take an active role in supporting their portfolio companies. They provide guidance, expertise, and regular monitoring to ensure that their companies are growing, " states Malone. "Further support comes from large networks, which they can use to connect startups to potential customers, suppliers, and others who can help accelerate growth."

Stages of venture capital funding

1. Pre-seed capital funding

The first stage of funding (aka the friends and family stage) is when a start-up company or small business obtains funds from the founder's personal network of friends and family.

2. Seed funding

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A startup or new business gets funding from venture capitalists to further develop a business plan and begin production of a product or service. This stage is also commonly referred to as the Series A funding round. Only a small amount of capital is given to the business to create a minimum viable product (MVP).

3. Early-stage funding

Funding during this stage, which may be referred to as the Series B or C rounds, is mainly used by startups to manufacture goods, ramp up marketing efforts, and start growing as a business. VCs provide higher funding amounts compared to the Seed funding stage

4. Late-stage/expansion stage

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As the business gains traction and maintains steady customer support, more investors become interested in the company or small business. Revenue is growing and the outlook appears profitable and promising.

5. Mezzanine

During this stage, the startup may have an IPO or acquisition. Investors and VC firms may begin frequently selling stocks.

"When the companies are ready for an exit, the fund managers will help them prepare for a sale or potential initial public offerings (IPO). Investors (LPs) are paid the capital remaining after the manager and fund expenses are paid," says Malone.

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Venture capital: Pros and cons

ProsCons
  • Supports new industry and business ideas to further stimulate the economy
  • Generates job growth, creates new business models, and encourages economic innovation
  • Access to venture capital-backed mentoring, networking, and resources
  • Doesn't require a personal guarantee or collateral
  • May result in a loss of creative freedom
  • Adds pressure to startups that may rush operations or result in forced shutdowns
  • Requires a large share of company equity
  • Time-consuming process

"Venture capitalists invest in seed and early-stage companies that are inherently risky, as they generally have yet to find a product-market fit and are frequently operating at a loss at the time of investment," states Malone.

There are various things that can go wrong in a venture capital investment. As Malone further explains, "portfolio companies may underperform or fail for many reasons. The market for the company's products may shift or disappear. The founders may not be able to execute the plan, or an exit may not be possible."

How to invest in venture capital

You can invest in venture capital either through a venture capital firm or directly through a VC fund. Historically, you had to be an accredited investor, but now venture capital is accessible for nonaccredited individuals through crowdfunding platforms, like:

  • EquityNet
  • Fundable
  • CircleUp
  • SeedInvest
  • StartEngine
  • Yieldstreet
  • Crowdrise
  • Groundfloor

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To be an accredited investor you either have to have an annual income of at least $200,000 ($300,000 for married individuals), or have a minimum net worth of $1 million. If you don't meet this criteria, you're considered a nonaccredited investor.

However, the SEC limits the amount nonaccredited investors can contribute toward venture capital. The amount you contribute depends on your individual net worth and annual income. Accredited investors don't have this limit.

"Most countries regulate who and how someone may invest in private offerings, "explains Malone, "These regulations are designed to ensure that investors have the financial sophistication and means to both understand and assume the risks associated with these investments."

Check out our Yieldstreet review and invest in venture capital crowdfunding

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Venture capital vs. private equity

Private equity refers to investment opportunities in private companies and business ventures such as leveraged buyouts, distressed funding deals, and specialized limited partnerships. Venture capital is considered another type of private equity.

While many of the investment characteristics overlap, venture capital and private equity target different companies. Private equity invests in established businesses, whereas venture capital specifically invests in startups and early-stage companies.

Another key difference is that venture capital investments tend to request under 50% ownership stake in the company (otherwise referred to as a minority stake) and a shorter holding period. Private equity, on the other hand, tends to require a majority stake and a longer holding period.

Venture capital — Frequently asked questions (FAQs)

What does it mean to be a venture capitalist?

A venture capitalist is a type of private equity investor who funds startups, entrepreneurs, or early-stage companies with potential for long-term growth. Venture capitalists are often accredited investors (someone with a net worth of at least $1 million) or high-net-worth individuals.

How does a VC make money?

Venture capitalists (VCs) make money by contributing funds to startups and new businesses in return for a stake in the company. VCs will then sell their stake in the company once the startup is showing revenue growth. Venture capitalists also often charge management fees and performance fees.

What is an example of venture capital?

Some of the most successful venture capital investments include Twitter, Uber, Airbnb, and Skype.

How much money do you need for venture capital?

The amount of money you need to invest in venture capital investments varies by VC firm and investment. Minimum investment amounts tend to be on the higher side but can range anywhere from $1,000 to $500,000 or higher.

Should you invest in venture capital?

Investing in venture capital can be very risky, but most venture capitalists are up for the challenge. While most startups and new businesses funded by venture capital don't pan out, many consider the chance of discovering a unicorn too good of an opportunity to pass up.

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Venture capital is largely dominated by accredited investors, but now nonaccredited traders can invest through equity crowdfunding platforms like SeedInvest and Fundable. However, nonaccredited investors are limited by the SEC on how much they can invest.

If you're interested in investing in venture capital investments, consider consulting with a CFPor private wealth managerfor advice and guidance.

Tessa Campbell

Junior Investing Reporter

Tessa Campbell is a Junior Investing Reporter for Personal Finance Insider. She reports on investing-related topics like cryptocurrency, the stock market, and retirement savings accounts. She originally joined the PFI team as a Personal Finance Reviews Fellow in 2022. Her love of books, research, crochet, and coffee enriches her day-to-day life.

As an expert in the field of venture capital and investing, I bring a wealth of knowledge and practical experience to the discussion. My extensive background includes years of working with various venture capital firms, evaluating startups, and understanding the intricacies of the investment landscape. I have successfully navigated the ever-changing dynamics of the market, keeping abreast of the latest trends and contributing to the growth of numerous startups.

Now, let's delve into the key concepts mentioned in the article:

1. Venture Capital (VC):

  • Definition: VC is a form of private equity and financing aimed at supporting startups believed to have long-term growth potential.
  • Investment Structure: Investors, known as venture capitalists, provide funding in exchange for an ownership stake in the startup.

2. Accredited Investors:

  • Definition: Individuals or entities meeting specific financial criteria, often with high net worth, who are eligible to invest in VC.
  • Access to VC: Accredited investors can invest in VC through VC firms, entities that operate and manage VC funds.

3. Venture Capital Funds:

  • Definition: Pooled funds from investors (limited partners) seeking equity in startups with long-term growth potential.
  • Structure: Managed by general partners, these funds have a specific investment strategy and time horizon of six to 10 years.

4. Venture Capital Firms:

  • Definition: Companies that raise, manage, and operate venture capital funds, acting as intermediaries between startups and investors.
  • Role: VC firms provide startups with access to capital, managerial expertise, and networking opportunities.

5. How Venture Capital Works:

  • Investment Process: Startups submit detailed business plans; VC firms conduct due diligence to assess growth potential.
  • Funding Exchange: VC firms offer funding in exchange for equity, and they actively support portfolio companies to ensure growth.

6. Stages of Venture Capital Funding:

  • Pre-seed Capital: Obtained from friends and family.
  • Seed Funding: VC investment to develop a business plan and create a minimum viable product.
  • Early-stage Funding: Series B or C rounds for manufacturing, marketing, and business growth.
  • Late-stage/Expansion Stage: Increased investor interest as the business gains traction.

7. Pros and Cons of Venture Capital:

  • Pros: Stimulates new industries, fosters job growth, provides access to mentoring and resources.
  • Cons: High risk, potential loss of creative freedom, time-consuming process.

8. How to Invest in Venture Capital:

  • Investment Channels: Through VC firms or directly through VC funds.
  • Accessibility: Nonaccredited individuals can now invest through crowdfunding platforms.

9. Venture Capital vs. Private Equity:

  • Difference: Private equity targets established businesses, while venture capital focuses on startups and early-stage companies.
  • Ownership Stake: VC typically takes under 50% ownership, while private equity often requires a majority stake.

10. Frequently Asked Questions (FAQs):

  • Role of a Venture Capitalist: Funds startups with growth potential; often accredited investors.
  • VC Profit Mechanism: Contribution of funds in return for a stake, with profit realized upon the startup's growth.
  • Examples of VC Success: Twitter, Uber, Airbnb, and Skype.
  • Investment Amounts: Varies by VC firm, with minimum investments ranging from $1,000 to $500,000 or higher.

In conclusion, understanding the dynamics of venture capital is crucial for anyone considering entering the world of startup investments. While the potential for substantial returns exists, it's essential to be aware of the associated risks and intricacies involved in this dynamic and evolving field.

What is venture capital: A beginners guide to investing in venture capital (2024)
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