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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. 

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. 

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.

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. 

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:

• 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. 

“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

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

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.

Venture capital: Pros and cons

“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

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

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)

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. 

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 CFP or private wealth manager for advice and guidance.