Facebook, Google, Airbnb, Alibaba, Spotify, WhatsApp, Snapchat, Twitter, Zoom, Dropbox, Uber, and Groupon all have something in common; two very important letters – VC. Venture Capital, or VC as it is often known, is a vital component of many of the largest companies operating in the world today. So, what is Venture Capital and how does it work? Let’s take a look.
What is Venture Capital (VC)?
Simply put, VC means investing in startup companies. It involves people or companies investing capital into a private company in return for equity, with the expectation of receiving a financial return on their invested funds. Looking back to times long past, companies were generally financed with debt instead of equity, where financiers would lend money to companies rather than buying shares in them. This started to change around halfway through the 20th century when financial systems and company structures evolved sufficiently to make it attractive and viable for investors to provide capital in return for an ownership stake in the company rather than as a loan. And so, VC was born.
A Venture Capitalist is an individual who invests money into companies, either directly (their own money) or as a manager of a VC fund (other people’s money).
Why is VC important and why do startups seek VC funding?
The old saying “Money makes the world go around” certainly rings true when it comes to companies. To grow and achieve success within a suitable time frame, companies require capital to invest in growth enablers such as materials, equipment, resources, people, technology, software, marketing, systems, real estate, and factories. These growth enablers require capital in advance of the income that can be generated by customers. That is where VC comes in – startups seek VC funding to raise the funds they need to pursue their vision and achieve their goals. It is important to understand that VC is not just about the money. Investors can also provide non-monetary benefits such as business guidance, mentorship, advice, and connections.
Real world examples of VC
Some real world Venture Capital examples are provided below to illustrate the power of VC not only for the financial returns it can bring to investors, but also the products and services it can help bring to the world1:
- Facebook in its early days raised capital in funding rounds starting in 2005 with a number of Venture Capital firms participating. When Facebook went public in 2012 at a valuation of $104b, early investors such as Accel Partners, Breyer Capital and other investors in that round turned their $12.7m investment into $9b.
- WhatsApp had a single Venture Capital investor throughout all its funding rounds – Sequoia Capital received a return of $3b on its $60m VC investment when Facebook purchased WhatsApp for $22b in 2014.
- Alibaba went public in 2014 with the biggest Initial Public Offering (IPO) on record, selling $22b worth of stock on a valuation of $167.6b. Japanese telecom company SoftBank was an early round investor in Alibaba, trading an investment of $20m in 2000 in return for a 34% stake in the company, which then turned into $60b at IPO.
1 Source – “From Alibaba To Zynga: 45 Of The Best VC Bets Of All Time And What We Can Learn From Them”, June 2021, CB Insights. Downloadable at this link. Of course, that is not to say that every venture capital investment succeeds. In fact, a large number of investments do not succeed and investors lose all of the money invested. Early stage venture capital is high risk and not right for all investors. More on that later in this article.
It is important to understand that VC is not just about the money. Investors can also provide non-monetary benefits such as business guidance, mentorship, advice, and connections.
VC funds, VC firms and Venture Capitalist explained
A VC fund is a pool of money that is used to invest in startups, and is usually the entity that makes an investment in a company. A VC firm is a company that manages a Venture Capital fund on behalf of the investors. Examples of significant VC firms include Tiger Global, Sequoia Capital, Accel Partners, and Andreessen Horowitz. A Venture Capitalist is an individual who invests money into companies, either directly (their own money) or as a manager of a VC fund (other people’s money).
How VC works
VC is a complex undertaking, full of risks and opportunities of varying degrees. A simple description of how VC works (in an ideal scenario) is as follows:
- A VC firm raises money by reaching out to their contacts and going out to the market to attract investors to join their fund. For example, if a VC firm received $10m each from 10 investors, they would have a fund of $100m.
- The VC firm then puts the fund to work by sourcing deals, which involves talking with entrepreneurs, evaluating their pitch, and doing due diligence on the company.
- If an opportunity meets the VC firm’s investment parameters, the VC will then invest in the company across one or more funding rounds.
- The VC firm monitors the activity and operations of the company to see that the capital is being deployed as agreed and to keep a close eye on company performance.
- As the company grows, develops, and matures, the VC firm seeks an exit such as a sale or public listing via IPO. There is no guarantee that an IPO or other exit strategy will occur.
- Upon exit, the VC firm realizes their profit, cashes in on their exit, and pays out returns to the VC fund investors, keeping a portion of the profits for the fund managers.
It is important to understand that the above description represents an ideal scenario. While the potential returns for VC funds can be significant , the potential for failure is very high and unfortunately all too frequent. Many startups fail, and investors can lose all or most of their investment. The Pareto Principle, commonly known as the 80/20 rule, is a guide often used in life and business. It is also considered by many to apply to VC funding, where a large proportion of the profits (the 80%) may come from a small number of the investments (the 20%). VC firms rely heavily on the home runs to compensate for the failures. VC funding enables a brand-new vision to come into being, with the potential for radically different ways of doing business and of learning. Think of some of the tools and platforms you use every day and try to imagine your life without them, such as Facebook, Google, and Airbnb to name a few. VC funding enabled these companies to innovate and to create the services that we know and love, and now perhaps take for granted.
Different stages of VC
VC funding rounds come in various stages, which are commonly described as follows:
- Seed stage investment is generally the first official funding round, occurring very early in a company’s life, and with a high risk of failure.
- Early-stage investment is for companies in the development phase, when they have demonstrated a potentially viable product, market, or service. These rounds are usually described by letters such as Series A, Series B, Series C, etc. Risk in these stages is still high, although it is lower than in the Seed round.
- Late-stage investment is for well-developed companies who have been through a growth phase and are now generating income but require more capital to reach profitability or additional growth. Each funding round is assigned a letter following on from the early-stage rounds, such as Series D, Series, E, Series F, etc. These later rounds are generally less risky than the early rounds.
Angel Investment vs. Venture Capital vs. Private Equity – what does it all mean?
A public company is one whose shares are traded on a public exchange such as the New York Stock Exchange, meaning that any member of the public can buy and sell shares at the current market price in those public companies. A private company is one whose shares are traded privately among the company and the shareholders, so the purchase and sale of shares is restricted. Private Equity refers to investments in private companies, in return for an ownership stake. Private Equity investments could be low risk or high risk and may occur at any stage in a company’s lifecycle, for example the investment could be in a well-established company. VC is a type of private equity because it involves investment in a private company. It is quite a formalized, structured process involving VC funds and VC firms deploying large investments, often in the millions of dollars. VC is considered a high-risk investment strategy.
Similarly, Angel Investing is also a type of private equity, and again is high risk. It differs from VC by being a more flexible process with lower investments, and can be accessed by individuals using angel investing platforms such as Propel(x). Should you consider Venture Capital as part of your portfolio? It is important for an investment portfolio to be well balanced, with a range of asset classes and varying exposure to investments with growth potential, depending on an individual’s financial position and personal circumstances.
Private equity, encompassing VC and Angel Investing, is an asset class that is worthy of consideration because of its potential for significant growth and return. Since people are putting their money at risk, they expect a high return but must keep in mind the potential for total loss of the investment. Cambridge Associates provides valuable data on returns across various asset classes including VC. Included below is a chart from their commentary on the year 20202
Their data for calendar year 2020 shows that returns from US Private Equity have outperformed the S&P 500 public market index across most multi-year returns from 1 year to 25 years, by a significant margin. For example, their 3-year returns data shows US Private Equity at 19.3% p.a. outperforming the S&P 500 index at 14.4% p.a. Of course, as with any investment it is critical to appropriately consider the high-risk nature of private equity when choosing where to invest your funds.
Technology has evolved and developed in recent years, which now provides private investors with the opportunity for angel investing in innovative startups with flexible investment minimums to allow portfolio diversification and help make a change that has the potential to impact the world. You can find more information here on how to start angel investing.