Venture Capital
What is Venture Capital?
Venture capital is money that specialized funds invest in young, high-growth companies in exchange for an ownership stake rather than repayment.
Venture funds gather pools of money from pension funds, endowments and wealthy individuals, then buy equity in startups that banks will not lend to, because those firms have no collateral and no reliable cash flow. The money arrives in staged rounds (seed, then Series A, B and onward), each priced at a new valuation and released as the company hits milestones, which limits how much is lost if the business stalls. Investors typically take a board seat and a say in major decisions. Most companies in a portfolio fail or return little, so a fund's result rests on the handful that grow very large. Venture capital differs from private equity, which buys control of mature, profitable firms instead of minority stakes in new ones.
Venture Capital: a worked example
A fund invests $2 million for a 20 percent stake, which values the whole company at $10 million after the investment ($2 million divided by 0.20). Four years later the company is bought for $50 million. If the fund's stake has not been diluted by later rounds, its 20 percent is worth $10 million, five times what it put in. Had the startup shut down instead, the fund would recover nothing, since equity holders are paid last and there is rarely anything left. Both outcomes sit inside the same portfolio.
The mistake students make with venture capital
Students picture venture capital as a loan the startup pays back with interest. It is equity: the fund buys shares, and if the company fails there is nothing to repay and the money is simply gone. The second half of the confusion is control. An early round usually buys a minority stake, so founders keep control at first, but every new round issues more shares and dilutes them.
Venture Capital questions
What is the difference between venture capital and angel investing?
Angel investors put in their own money, usually at the earliest stage and in smaller amounts, while venture capital firms invest money raised from outside investors in larger, later rounds. Angels often decide alone and quickly, whereas venture funds run formal diligence and take board seats. A company frequently raises from angels first and from venture funds afterward.
How do venture capital funds make money?
Venture funds charge their investors an annual management fee based on the capital committed and keep a share of any investment gains, known as carried interest. Those gains are realized only when a portfolio company is sold or lists its shares publicly. Because most investments return little, a fund's outcome depends heavily on its few largest successes.
What is a Series A round?
A Series A is normally a startup's first large round led by an institutional venture fund, arriving after founder money, friends and family, angels or a seed round. It is priced at an agreed valuation and usually buys preferred shares with extra rights attached. Its purpose is to scale a product that already has customers, and later rounds continue through the alphabet.
Related terms
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