To put it simply, a venture capitalist is someone who invests in emerging businesses who cannot obtain a bank loan for one reason or another. These companies generally need both guidance and funding and are offering a new, viable product or service with a strong advantage over any competing businesses (if any exist at all). Most venture capital comes from firms, and because such investments are considered to be substantial risks, the return on investment can also be quite substantial as well.
What Does Venture Capitalist Mean?
Venture capitalists are investors who provide funding to startup companies or growing small businesses that may have promising ideas or technologies to invest in but do not have enough collateral, cash flow or a have too high of a risk profile to obtain a business loan or other forms of funding. While these investments are risky, the venture capitalists generally are wealthy enough to weather any losses (even those that are substantial), and they have the expertise to help fledgling companies. As a result, the return on the investments is much higher than the venture capitalist would ordinarily see through traditional investment opportunities such as stocks.
While a company in any industry could technically receive investments through a venture capitalist, the majority of venture capital goes to businesses in the tech industry.
How Venture Capitalist Firms Work
While most people envision venture capital to come from one wealthy individual, the majority of it comes from professionally managed firms that may be either public or private. These firms operate solely with the purpose of seeking out profitable businesses to invest in that will provide the many investors in the company with high rates of return.
Venture capital firms are funded by wealthy individuals, pension funds, foundations and insurance companies who pool their money together. Under this business structure, all partners will have part ownership over the overall fund, but the firm itself will determine where the money will be invested. While numbers will vary by firm, around 20 percent of the profits will be paid to those who manage the firm, while the rest will go to the partners. The firm may also earn management fees on top of its share of the profits.
While these firms were once managed by a balance of bankers and former entrepreneurs, bankers are increasingly getting pushed out for the latter as experience in the specific industry has largely proven to be more beneficial to venture capital firms than experience handling finances, which is not as important in the early stages of a company. Since venture capital firms help guide the companies they invest in, a knowledge of both the industry and its major players can be a substantial advantage to both the firm and the companies seeking funds.
These companies may range in size from small firms with only a handful of investors who have only a few million dollars that will go to a few businesses each year to huge companies with many investors, billions of dollars in assets and investments in hundreds of companies.
Should You Seek Venture Capital?
Like all things, there are many advantages and disadvantages to using venture capital to fund a business, and it is a decision that should not be taken lightly. The most obvious disadvantage is that the high risk associated with venture capital carries high returns, so if your company does well, you will likely have to give up 25 percent or more of your profits. That's why most companies that can qualify for a business loan will find themselves a lot better off financially if they head to the bank rather than to a venture capital firm. On the other hand, if you can't get a bank loan, particularly one large enough to meet your business goals, venture capital funding might be the only option you have.
Another drawback of securing a venture capitalist for your company is that most deals involve losing the majority of shares of your business or giving up veto rights. Many venture capital firms won't accept a deal that leaves them with less than 50 percent of the shares. This is because they want to obtain a majority of the voting rights in the company so they can help direct the business to earn the most profit for their investments. The firm will generally take an active role in the business by supplying a board member and becoming involved in all significant management decisions including those that involve additional financing, major business expenditures, selling the company or the decision to go public. If you don't want to give up control of your company, you might want to avoid venture capital if at all possible. If this is a problem for you, it might be preferable to seek out an angel investor if you can.
Having a venture capital firm help guide your business could be a benefit for many young companies and inexperienced CEOs though as venture capitalists tend to have extensive knowledge in the field and will often be able to guide a company through difficult times that can sink many startups. Many businesses seek venture capital not solely due to financial concerns, but also to obtain valuable knowledge and experience from someone who will do everything reasonable to see them succeed.
As a notable example, Bill Gates sought out venture capitalist Dave Marquardt to help guide Microsoft in 1981 even though the company did not need any financial investments at the time. Marquardt was the only venture capitalist to invest in Microsoft and remained on the company's board for over 30 years.
Obtaining Venture Capital
At any given moment, there are probably thousands of entrepreneurs and inventors thinking "how do I find a venture capitalist?" But most businesses do not qualify for venture capital funding and firms are incredibly selective about which companies and products they invest in. According to the U.S. Small Business Administration, less than .1 percent of businesses are funded through venture capital. Most companies are funded by the business owners themselves or through angel investors.
Generally speaking, companies that appeal to venture capitalists will be those in the startup stage with a viable and unique product or service that has a large potential market and a strong competitive advantage. Aside from that, venture capitalists usually look for businesses in industries they are already familiar with that have a strong management team. They will also often limit their investments to companies that will allow them a majority stake in the company so they can guide its direction.
How Venture Capitalists Make Money
As for what do venture capitalists get in return, the investor will provide funding for a share of equity in the company. In general, due to the risks associated with their investments, venture capital firms expect to see a return on their investment of 25 percent or more. Most of these investments are long-term and typically last from five-to-eight years as that is how long it will take a startup to mature enough for the venture capital firm to see the kind of returns it is looking for. And a successful company will often either get bought out or go public at this point.
In some cases, a venture capitalist will hold on to his shares if he feels the investment will yield consistently high returns, but in most cases, the investor will give up ownership at the time the company goes public or gets sold. This way, the investor can take his earnings and invest in a new prospective startup company.
If the company fails, the venture capitalist will experience major losses and will often fail to recoup any of the money invested. This is why most venture capitalists are either incredibly wealthy and able to afford financial losses of these kinds or involved in the pool that makes up a venture capital firm.
Venture Capitalist Versus Angel Investors
Venture capitalists and angel investors are similar in that they both provide financial investments, guidance and other assistance to young companies. The biggest difference between the two is that while a venture capitalist will generally want to take control of a company, which is why they are often nicknamed "vulture capitalists," an angel investor will only play an indirect role as an adviser in the company, which is why it is called an "angel investor."
Another major difference is that while most venture capital comes from firms rather than individuals, most angel investors are simply wealthy individuals, though a few will operate in very small groups.
Famous Examples of Venture Capitalists
Like Dave Marquardt investing in Microsoft, many of the largest tech companies in the world were created with the assistance of venture capitalists. A few of the most famous venture capitalists include Jim Breyer, who was an early investor in Facebook; Peter Fenton, an investor in Twitter; Jeremy Levine, the largest investor in Pinterest and the first investor in Facebook; and Chris Sacca, an early investor in both Twitter and Uber. As for well-known venture capital firms, Accel Partners has invested in Facebook, Etsy and Dropbox and manages over $6 billion in pooled funds, and GV (previously known as Google Ventures) is Google's venture capital firm that has invested in both Uber and Slack.
A History of Venture Capital
Harvard instructor and investment banker Georges Doriot started the first publicly owned venture capital firm, American Research and Development Corporation (ARDC) in 1946. This was the first time a startup had the option to raise money from private sources aside from wealthy families such as the Rockefellers or Vanderbilts. Educational institutions and insurers invested millions through ARDC. Doroit is now known as the "father of venture capitalism."
Former employees of ARDC went on to start venture capital firms such as Morgan Holland Ventures and Greylock Ventures and many other firms copied this model. These early companies were the founders of what eventually grew into the venture capital industry known today.
One of the first major venture-capital-backed startups was Fairchild Semiconductor, which was considered a very risky investment at the time as it was one of the first semiconductor companies. In the end, the company became one of the most successful companies of its kind and helped establish a pattern for successful partnerships between venture capitalists and emerging tech companies in San Francisco's Bay Area.
The number of independent venture capital firms increased through the 1960s and 1970s, peaking in the late 1970s and early 1980s with the success of companies like Apple. Many firms started posting some of their first losses in the mid-1980s after the industry became oversaturated with competition both inside and outside the U.S. all seeking to find the next Microsoft or Apple. Venture capital funding started to slow at this point, but by the mid-1990s, the industry started to pick up again only to get hit hard in the early 2000s when the dot-com bubble burst. After the market began to stabilize again, venture capitalists returned in full force and are now thriving thanks to social media, bio-medical, mobile and other modern technologies.
- Investopedia: Venture Capitalist
- How Venture Capital Works
- Business Dictionary: Angel Investor
- GV: Homepage
- Founder's Guide: American Research and Development Corporation
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