What is Venture Capital and How Does it Work?

An Overview of Venture Capital

When entrepreneurs want to start a business, one of the first things they need to do is secure financing. Venture capital (VC) is one of the options that entrepreneurs have for that financing: it is the money that’s given to early-stage companies to help spur their growth.

New startups often turn to venture capital because they are too new and therefore too risky for more traditional forms of financing like bank loans. Instead of repaying the loans with added interest, venture capital firms usually require a portion of ownership of the startup instead. In return, they get a say in the future strategy of the company and hope to see large returns when the company is acquired or goes public.

By its nature, venture capital investments are risky, and the possibility of large losses is built into the venture capital industry. Venture capitalists make the bet that a few very successful venture-backed companies will pay dividends that can offset the failed investments. Regardless, venture capital funds provide new businesses with the chance they need to be successful in an otherwise difficult financing environment.

Those who invest money in venture capital funds that are then in turn put into portfolio companies or even large venture capital firms are called limited partners (LPs). Those who manage the fund and work with the individual companies are the general partners (GPs) or venture capitalists. The general partners work closely with the companies they invest in to ensure that the company is growing profitably. Because of the nature of the financing, relationships between the venture capital firm and the companies can last for 5–10 years before any money is repaid. At the end of the investment period, venture capital funds can sell their shares back to the owners or through an initial public offering (IPO).

How Does Venture Capital Work?

At the very beginning of the startup’s life, companies often “bootstrap,” or use personal funds or the funds of friends and families to jumpstart operations. When that financing is no longer sufficient and the startup needs to scale, founders will begin to turn to more formal financing sources.

Venture capital is a good first choice for early-stage startups because of its aforementioned built-in risk and nontraditional repayment options. There are many different VC firms out there—some target specific industries, geographical areas, or stages of company development. Companies looking to source money from venture capital VC funds should first create a pitch deck to send to the firms that are a good fit for their business. If they are interested, they will do their due diligence and analyze the potential of the startup.

If both parties agree that it is a good fit, the general partner will present a term sheet that will include the amount to be invested, the equity stake the fund will receive, and any other conditions present in the deal. Most of these conditions are negotiable, and the startup should make clear its priorities internally before entering those negotiations.

Most of the funding from venture capitalists goes into the adolescent phase of a company’s life cycle when it is difficult to predict its financial success. The money from VC funds is not a long-term investment. These firms typically want to invest money early in the company’s lifetime, help it get to a self-sustaining size, and then receive their return on investment once the company is sold or goes through an IPO.

Venture Capitalists and Their Role

Venture capitalists play a crucial role in the success of startups. They are typically the general partners (GPs) who actively manage the portfolio companies in which they have invested. These professionals are responsible for identifying high-growth potential startups, conducting due diligence, and nurturing their growth.

Their work doesn’t end after making the venture capital deal—they often sit on the boards of the companies, offering guidance and ensuring the business stays on track.

Venture Capital vs. Private Equity

Often confused for one another, venture capital and private equity (PE) can overlap but operate on distinct business models. Both VC firms and private equity firms are a means of providing financial investment to companies. However, the kind of business they invest in, the stake they require, and the exit strategy are different.

Venture capital firms like to invest in startups and companies going through their “adolescent” phase. While typically at high risk, they also have the potential for higher returns. In return, the company offers a minority stake. Once the company is sold or goes through an IPO, the venture capital firm will typically cash out and move on to its next venture.

Private equity firms have a different approach. Instead of startups, they will usually invest in companies that are established but struggling because of management or processes. Private equity firms require a majority stake in the company because they are not just providing funding; rather, the PE investors will try and make significant improvements from within the company with the goal of reselling the business for a profit.

Read more about private equity here: What is Private Equity and How Does it Work?

Jobs in Venture Capital

From an entry-level position to management, those who work in venture capital are all responsible for the sourcing and supporting of deals. The entry-level jobs available at VC firms are typically “VC Associate” roles. Associates will do most of the sourcing and screening of potential companies. They will call companies, set up meetings, and eventually present prospective companies to the firm’s partners. Associates will also support the companies in which the firm has already invested. This may include running analytics on the company’s health and doing other forms of due diligence.

Most VC associates do not yet have their MBA and are expected to get one. In fact, some Associate contracts are only for two years for this reason. Post-MBA associates are more on the track for firm partnership. The traits required vary dramatically depending on whether the firm specializes in early-stage or late-stage deals and if it is industry-specific or takes a broader approach. Generally, VC associates are paid an annual salary of $75,000 to $150,000 and will also receive bonuses based on their performance and the deals they’ve been involved in.

Read: Jobs in Venture Capital: Your Guide to Employment

Portfolio Companies and Venture Capital Investments

The startups that receive funding from a VC fund are referred to as portfolio companies. These companies represent the investments made by a venture capital firm. Each VC fund typically invests in multiple portfolio companies to diversify the risk associated with early-stage businesses.

Startups that become part of a portfolio gain not only capital but also access to the expertise and networks of venture capitalists.

Institutional Investors and Limited Partners in Venture Capital

Many top venture capital firms source their funds from institutional investors, which include entities like pension funds, corporate pension funds, and high-net-worth individuals. These investors, collectively referred to as limited partners (LPs), provide the bulk of the capital that venture capitalists use to invest in startups. Unlike general partners (GPs) who manage the funds and make investment decisions, LPs are typically passive investors, receiving returns based on the fund's performance.

Pension funds, for instance, allocate a small percentage of their large portfolios to venture capital as a way to diversify and achieve higher returns, while corporate pension funds invest strategically to drive innovation in industries relevant to their core business. Meanwhile, high-net-worth individuals often participate in venture capital as a means to access high-growth opportunities that may not be available through traditional markets.

Organizations like the National Venture Capital Association (NVCA) act as a bridge between limited partners and venture capital investors, offering educational resources, networking opportunities, and advocacy efforts to foster growth in capital markets and encourage innovation across industries.

Angel Investors, Hedge Funds, and Venture Funding

In the early stages of a company’s lifecycle, startups often depend on angel investors—wealthy individuals who provide capital in exchange for equity stakes in the business. These investments are typically smaller and less structured than those made by venture capital firms, but they are crucial for startups that need funding to develop a product or validate a business model.

As startups grow and achieve key milestones, they may attract larger investments through VC funding rounds. At this stage, venture capital firms bring not only money but also mentorship, industry connections, and strategic guidance. As companies mature further, some may secure additional funding from hedge funds, which are often interested in later-stage businesses with proven scalability and growth potential. These investors seek to diversify their portfolios by investing in high-growth companies that are on the path to public offerings or acquisitions.

This progression through various stages of venture funding enables startups to expand their operations, enter new markets, develop innovative products, and increase their overall valuation, positioning them for long-term success.

The Impact of Venture Capital on Capital Markets

The infusion of venture capital into the economy fuels innovation and creates ripple effects throughout capital markets. By investing in startups that pioneer new technologies and disrupt traditional industries, venture capital firms not only generate returns for their limited partners but also drive job creation, economic growth, and technological advancement.

Institutional investors like pension funds and corporate pension funds play a critical role in this ecosystem by providing the financial resources that make these high-risk, high-reward investments possible. The collaboration between these funding sources ensures that startups have the capital they need to thrive in competitive markets. Additionally, the success of venture-backed startups often leads to secondary benefits, such as increased IPO activity and acquisitions, which further energize capital markets and attract additional investment.

Raising Capital Through Venture Capital Investors

For startups seeking to raise capital from venture capital investors, preparation is key. Founders must craft a compelling pitch that highlights their company’s growth potential, market opportunity, and competitive edge. This includes presenting a clear and scalable business model, demonstrating a strong understanding of the target market, and showcasing a capable team with a track record of execution.

In addition to these fundamentals, startups must be ready to address potential investors' concerns, such as how they plan to mitigate risks, achieve profitability, and deliver substantial returns. Building relationships with venture capitalists is just as important as the pitch itself, as trust and alignment of vision often play a decisive role in securing funding.

By meeting these expectations, startups can increase their chances of securing the funding they need to achieve their goals, whether through early-stage angel investments, mid-stage VC funding, or later-stage financing from hedge funds.

Final Note

Jobs in venture capital are competitive but with the right help, they are attainable. Leland provides you with the content, community, and coaching that you need to get into your dream venture capital job and accomplish other ambitious goals.

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FAQs

What are the stages of venture capital financing?

• Venture capital financing typically progresses through stages: seed funding (early concept), Series A (market entry), growth stages (expansion), and late-stage funding (exit preparation).

How do venture capitalists evaluate investments?

• Venture capitalists assess startups based on market size, product viability, team expertise, traction (user growth or revenue), and competitive advantages.

What is the typical duration of a venture capital investment?

• Investments usually last 5 to 10 years, providing startups with the time to grow and achieve significant milestones for an exit.

What are common exit strategies for venture capital investments?

• Exits include initial public offerings (IPOs), acquisitions by other firms, and secondary sales to private investors.

What are the risks of venture capital investing?

• Key risks include startup failures, illiquidity, market volatility, and potential ownership dilution from future funding rounds.