Venture Capital

What Is Venture Capital?

Venture capital (VC) is a form of private equity (PE) financing in which investors buy stakes mostly in young companies in need of financing. Unlike PE funds, which typically invest in more established companies, VC firms invest mainly in startups, particularly in technology, biotechnology, financial services, payments and other businesses that show promise for growth.

VC firms operate the same way as PE firms in that besides funding, they also often provide technical expertise and management experience to the companies they invest in. However, they tend not to be as actively involved as PE firms, which often actually run the companies they invest in. In addition to obtaining equity in the company, VC firms often get seats on the company's board of directors to help advise the company.

Many of the most valuable and best-known startup companies have received venture capital financing, including:

  • Uber
  • Lyft
  • Twitter
  • Instagram
  • WeWork
  • Slack
  • Airbnb
  • Stripe
  • Social Finance
  • Credit Karma
  • DoorDash

Some of these companies have already gone public while others are planning to do so.[1]

High Risk, High Reward

VC firms look for companies with a unique product or service, a large potential market and a competitive advantage. Since many startups fail to live up to their initial promise or fail altogether, VC investing is typically high risk. As a result, VC firms are generally very selective about which startups they will commit money to.

However, for those investments that do pay off, they earn large returns generally unavailable in the public stock market. As with private equity in general, VC investments often take years to bear fruit.

VC firms raise capital from mostly large institutional investors, such as pension funds, university endowments, Wall Street investment banks, insurance companies, wealthy individuals and family offices.

Startups seek VC funding because they often can't obtain bank financing because of their lack of profitability, insufficient cash flow, lack of collateral, a risky business model or some other issue. Being financed by VC firms also gives the companies, which often take years to become profitable, the freedom to not have to report their quarterly results to the public markets.[2]

The "Father" Of Venture Capitalism

Georges Doriot is generally considered to be the "father" of modern venture capitalism. Born in France in 1899, he eventually moved to the U.S. and attended Harvard Business School—but did not graduate—and later taught there.[3]

During World War II he joined the U.S. Army, where he became director of the Military Planning Division in the Office of the Quartermaster General. After the war, he retired as a brigadier general and in 1946 he founded American Research and Development Corporation (ARDC), the first publicly-owned VC firm.[3]

Among ARDC's most successful VC investments was in Digital Equipment Corp., one of the first manufacturers of minicomputers. The company which was founded in 1957, and it was acquired in 1998 by Compaq Computer Corp., which later merged with Hewlett-Packard.[3]

Top VC Firms

The following are considered to be among the largest venture capital firms:

  • Accel
  • Andreessen Horowitz
  • Benchmark
  • Index Ventures
  • Sequoia Capital
  • Bessemer Venture Partners
  • Founders Fund
  • GGV Capital
  • IVP[4]

Summary

Venture capital is a subset of private equity that concentrates on making investments in young, startup companies with a large potential for growth. Like PE in general, VC firms make equity investments in companies while also providing them with technical expertise and managerial experience.

VC investments often take years to bear fruit, and many of them never do. As a result, VC investing is often high risk but also high reward. Many of the best well-known growth companies of today were financed with VC seed money, including Uber, Stripe and Airbnb.