A Beginner’s Guide to Venture Capital – What Is VC and How Does It Work?

One of the exciting conundrums of society has been the hindrance of financial literacy for students, the younger generation, and almost everyone. Some point to the lack of financial education in the school system, while others believe they can learn finance independently. Today, wealth creation has a new blessing in disguise – venture capitalists.

 Defining venture capital 

The financial jargon complicates things for people new to the investment world. Let me simplify these complexities for you. By definition, venture capital (VC) is a form of private equity and financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential like teck hustlers.

 Generally, venture capital comes from well-off investors, investment banks, and other financial institutions. However, it does not always take a monetary form; it can also be provided through technical or managerial expertise. Venture capital is typically allocated to small companies with exceptional growth potential or companies that have increased and appear poised to continue expanding.

 Though it can be risky for investors who put up funds, the potential for above-average returns is an attractive payoff. For new companies or ventures with a limited operating history (under two years), venture capital is increasingly becoming a popular source for raising money, especially if they lack access to capital markets, bank loans, or other debt instruments. 

What is a venture capitalist?

Investors working at a venture capital firm are called venture capitalists. They actively seek investment opportunities for the firm and help raise capital for venture funds. In 2021, there was a massive hike in active VC investors globally. To put that into perspective, the number of active VCs has doubled since then. 

A common misconception arises when people need clarification on angel investors with venture capitalists. An angel investor is a wealthy individual who invests money into promising companies, whereas a venture capitalist raises and invests capital from limited partners.

How does venture capital work?

The venture capital process involves several parties, including entrepreneurs and limited partners. The business’s founders or owners need capital and expertise to advance their business concept. Others are limited partners who are private investors willing to invest in higher-risk startups to capture outsized returns and diversify their investment portfolios. Apart from the two partners, venture capitalists or VC firms provide resources for aspiring startup companies and raise funding by offering investment opportunities to limited partners. These resources could be capital, know-how, and networking.

Another essential component gelling the entire system is the role played by investment bankers. These people are deal-makers who look for companies to sell via mergers and acquisitions or other types of capital raising, such as initial public offerings. The VC firms connect all parties by spending time vetting entrepreneurs and startup companies to seek out profitable deals. VC firms supply funding and guidance to entrepreneurs to help their businesses succeed. They stay in touch with investment bankers to assess potential exit options and ensure the smooth working of the entire process.

Stages of venture capital

During the venture capital process, many startups navigate through multiple stages or rounds of financing. Without further ado, let’s delve into details about these stages:

Seed – During this first stage of development, the normal flow entails entrepreneurs presenting and showcasing their business plans. Through strategy demonstration and bringing unique ideas to the table, they use seed capital for research and development to determine their product offering, target market, and business strategy. At this particular stage, angel investors are actively involved.

Early – The next step is when the business moves to scale production, operations, and marketing. Once the business process is kickstarter, it paves the way to raise the first round of funding, called Series A. If the business expands, successive rounds (Series B, C) may follow.

Late – When the business prepares for M&A or an IPO, it may issue additional funding rounds (Series D, E) to create the ideal market conditions for VC investors to exit the startup.

 How do venture capital firms make money?

Venture capital firms make money by collecting management and performance fees. Varying from fund to fund, the typical fee structure follows the 2-and-20 rule:

Management fees – Calculated as a percentage of assets under management (AUM), typically around 2%. These fees are intended to cover daily expenses and overhead and are incurred regularly. 

Performance fees – The performance fees are calculated as a percentage of the profits from investing, typically around 20%. These fees incentivize greater returns and are paid out to employees to reward their success.

Difference between venture capital and private equity

Venture capital and private equity share the same goal: to increase the value of the business they invest in and then sell their equity stake for a profit. However, these could differ in many ways. The difference would be noticeable depending on the type of companies they invest in, capital levels, amount of obtained equity, etc.

Conclusion

Venture capital firms typically source most of their funding from large investment institutions such as superannuation funds and banks. These institutions invest in a venture capital fund for up to ten years. To compensate for the long-term commitment and lack of security and liquidity, investment institutions expect to receive very high returns on their investment. So if you are not invested in venture capitalists’ investments, start today!