What Is Venture Capital?

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Venture capital is a kind of investment raised by startups—typically by startup founders—to fund growth. Now let’s break that down.

A startup is an emerging company, typically private, that aspires to grow quickly and substantially in size and revenue.* Once a company is established in the market and has been successful for a while, it usually stops being called a startup.

confusion The term startup does not have legal significance, and in fact, there is no formal, consistent definition for what a startup is.

Startups are not the same as small businesses. Small businesses, like coffee shops or plumbing businesses, typically intend to grow slowly and organically, while relying much less on investment capital and equity compensation. Distinguished startup investor Paul Graham has emphasized that it’s best to think of a startup as any early-stage company intending to grow quickly.* Similarly, The Kauffman Foundation, devoted to encouraging entrepreneurship, categorizes startups as “innovation-driven enterprises” that require innovation in “product, process, or business model,” whereas small and medium-sized enterprises (SMEs) “tend to be individual or family owned with little outside investment.”*

Definition An entrepreneur is an individual who starts a company, and a founder is a type of entrepreneur whose company is a startup. Solo founders start their companies alone, whereas co-founders share the founder status between two or more people. Many founders also run their companies in at least the first years.*

confusion Occasionally individuals describe themselves as entrepreneurs—but not as founders—if they have key roles at a company they did not, in fact, start. Some would call these entrepreneurs “early employees” instead.

In almost every case, the term founder is used to describe the people who started, or founded, a company. It is rare but sometimes possible for a senior person to negotiate a co-founder title when joining a company after it’s founded or to be given a co-founder title if they contributed profoundly to a company’s mission or development early on.

Definition Fundraising (or financing) is the process of seeking capital to build or scale a business. Forms of fundraising include selling shares in a business, loans, initial coin offerings, and selling securities that convert into shares.

While public companies can finance their operations through revenue or by selling equity in the public markets, private companies need to bring in cash in other ways. Typically, it is the startup founder (or one of the founders) who does the work of securing financing for the company. In the case of raising venture capital, this broadly means developing a business plan, researching and meeting with investors, and negotiating a deal.

Definition Venture capital is a form of financing that individual investors or investment firms provide to early-stage companies that appear capable of growing quickly and commanding significant market share. This financing is generally offered in exchange for equity in the company. Venture refers to the risky nature of investing in early-stage companies—typically startups—with unproven businesses. Investors who provide this financing are called venture capitalists (or VCs).

confusion The term VC is often used to refer to venture capital firms, individual venture capitalists, and the broad category of investment into risky businesses.

Venture capital is, by its nature, a dance between the interests of founders and investors. Venture capitalists aim for the capital (financial assets or money) they invest in a startup to dramatically increase in value over time, as the company grows. That value will be paid out to investors, founders, employees, and others who hold stock in the company in the event of some kind of exit. To maximize the chances of an increase in the value of a company’s stock and in a successful exit, venture capitalists often provide mentorship, connections, and more to the founders they fund.

On the other hand, the venture capital business model doesn’t care if your company fails—it relies, as we’ll explain, on the massive success of only a few companies. Venture capital pushes companies to grow very big, very quickly, and venture capitalists can pressure or even force founders into making decisions for their businesses that serve that growth over all else. No matter which financing structure is used in an investment deal, venture capitalists are always purchasing part of a company. Founders want to hold on to as much ownership as they can—because more equity usually (though not always) means more control—while raising sufficient money for their company to achieve desired growth.

Where investors and founders are usually aligned is in building an innovative company. Startups seek to provide something—like a product or technology—that is new to a market and has the potential to transform that market. Different investment mechanisms evolved to serve different purposes, and the venture capital firm exists to finance truly innovative companies that need the capital to experiment with a new idea.

These innovative companies are rarely obvious to spot early on and it takes a highly skilled VC (or a very lucky one) to do so. In 2007, Logan Green, the founder of Lyft, was vaguely excited about carpooling—so much so that he got beaten up in New York for commenting on five men crowding into a Mercedes late at night.* Still, it wasn’t until 2010 that either Lyft (called Zimride at the time) or Uber (UberCab back then) raised a $1M+ round.** By that point, Zimride had gained traction with carpoolers on university campuses, and UberCab was targeting San Franciscans tired of notoriously unreliable taxis—neither had yet launched the peer-to-peer ridesharing services used today. While the success of these companies looks obvious in retrospect, only a small handful of investors took a risk on either of these companies early on.

Figure: Historical Monthly U.S. Venture and Angel Funding

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Source: Crunchbase*

VC Firms and Funds

Definition A venture capital firm (VC firm or venture firm) is a collection of legal entities formed for the purpose of generating substantial returns for its investors by investing in high-risk companies that have yet to prove that their business models work and are sustainable in the marketplace.

Definition A venture capital fund (or venture fund) is a legal entity, created by—but separate from—a VC firm, that pools money from outside investors and directs investments to companies seeking capital. Venture capital funds are typically structured as partnerships.*

It is helpful to understand venture firms as institutional investors to differentiate them from other kinds of startup investors, such as angels, and when contrasting institutional venture rounds from angel rounds.

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