So what, exactly, is venture capital?
Everyone has heard of it, but how many people actually understand it
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Mention venture capital to most people and they think the Internet, Silicon Valley, and futuristic startups run by 20-something whizkids from their laptops.
They’re not wrong, but they are missing a much bigger picture of an industry that emerged from the ashes of WWII.
It was 1946, and the government’s widespread economic intervention during The Depression of the 1930s still weighed heavily on American businesses. However, the war had brought a lot of changes, including a wave of cutting-edge technology and a renewed willingness to take risks.
Sensing an opportunity, a French immigrant and Harvard professor named Georges Doriot raised a new type of fund that would invest in these promising technologies and a new generation of post-war entrepreneurs.
The fund’s first investment was $200,000 in a company that used x-rays to treat cancer. It returned $1.8 million when it went public in 1955. Another investment of $70,000 in Digital Equipment Corporation in 1957 did even better, returning more than $38 million at an IPO less than 10 years later.
For more than 75 years, venture capital has been investing in promising yet incredibly risky ideas, often ending in failure but sometimes succeeding spectacularly.
And yet, despite this long and interesting history, and its very high profile in the business world today, a surprising number of people still have a murky understanding of what venture capital actually does.
In this primer on VCs, we will explain what they do — or to be more exact — how VCs raise, invest and ultimately make money.
What is venture capital?
Venture capital is a high-risk, high-reward investment in young businesses and early innovations that have the potential for explosive growth; but also the potential to fail completely.
The investors behind these VCs are people and organizations who are willing to lose their money. They are willing to accept losses in 9 companies for a chance that the 10th will be the next Grab.
They understand that for every Google, Facebook and Alibaba that was initially funded by venture capital, thousands of others have disappeared and been forgotten forever.
What is a venture capital firm, and how does it differ from a VC fund?
A VC firm is a legal entity established to make high-risk investments. VC funds, meanwhile, are the separate pools of money that the VC firm raises from outside investors. Each VC fund is designed to focus on a specific industry, technology or strategy.
When Georges Doirot set up his VC in the late 1940s, for example, his strategy was to finance “noble ideas” that could benefit humanity following a devastating world war.
Today, with the world becoming so much more complex and specialized, the funds in a VC’s portfolio must be equally specialized. A fund may focus on breakthroughs in blockchain and artificial intelligence, or they may target more holistic initiatives such as renewable energy and food security.
Whatever their focus, these VC funds are usually structured as partnerships. The investors are Limited Partners, commonly known as LPs, while the people managing the funds are called General Partners.
When do VCs invest?
The short answer is early. VCs look for very new opportunities that have the potential of explosive growth over the next 10 years. These early investments are divided up into several phases.
Pre-seed is the earliest. It’s the stage where founders are trying to transform an idea into a business plan. They are reaching out to family, friends and high-net worth people sometimes known as Angel investors for both money and advice.
Seed is when a company is ready to launch its first product and typically where VCs begin to show up. Without any revenue, the business needs funding to pay for the employees and marketing that will help them find, contact and secure their first customers.
Early stage: After a business has developed a product and found its first customers, it needs to increase production and sales before it can finally become self-funding. Financing during this period can be spread over several rounds as the business begins to scale. Series A and Series B rounds will see VCs funding new products and new markets, as well as acquisitions that help the company grow as rapidly as possible.
Late stage: By this time, a company has a stable of core products and strong market presence. Funding during this period, often called Series C and D, continues to scale the business while preparing the company for a public offering. It’s a period when more large investors begin to get involved while some of the smaller, early investors decide to cash out.
When discussing these different stages of investing, it’s also important to understand a term called pro-rata rights. As more investors finance a company there is a risk that earlier investors will see their equity be diluted.
To protect their stake, VCs will often ensure they have pro-rata rights; or the right to continuously top-up their investment so their share of equity in the company remains constant.
How do VCs earn their money?
There are two ways a VC makes money. There are the management fees that a VC charges for running a fund, and then there’s the return on a successful investment that can add up to many multiples of the initial outlay.
This arrangement is often referred to as ‘2 and 20’ with the management fees at 2% and the VC’s share of the profit typically benchmarked at 20%.
Since the management fees have to cover the cost of running the fund — including the research, analysts and other expenses — it’s the share of the profit that earns a VC the bulk of its earnings.
More than just investors
There’s another important point to make about VCs. The long journey from a good idea to a successful IPO can take up to 10 years or more and requires that a VC adopt a very hands-on role. They mentor and guide the founders, and often step up at key moments of the journey.
When the founders of HashiCorp wanted to hire the seasoned executive David McJannet as their CEO for example, they turned to their board member and VC partner Glenn Solomon of GGV Capital for help.
“I was like, I don’t really want to do this,” McJannet said. “(But) Glenn bought me a beer and said: if you do this, I’ll put in $15 million behind you, whatever number to de-risk it for you. So I said, okay.”
The partners at VCs use this network of contacts, their industry knowledge, and deep experience advising other startups to provide founders with the operational expertise to run their companies day to day, as well as the long-term vision that improves their chances of success in the years to come.
Conclusion
As 2022 has shown, venture capital is incredibly risky.
It’s bad enough that VCs can earn nothing for years while hoping one or two investments will make up for all of their losses. Sometimes a year like 2022 comes along, and everything is plunged into the red, both the good and the bad.
But venture capital has been around for a long time. It’s survived worse, and will be around for a long time to come.
