What Is Venture Capital Investing?

Venture capitalists are the investors on the prowl for the next Facebook, Uber, or AirBnB. Armed with billions in investor cash, venture capital (VC) funds seek to invest in some of the best new businesses and ideas, pool them together in a fund structure and hope that a few star performers materialize and change the world. But behind the star names driving the headlines, most venture capital firms look to generate a solid return on their performance. Think about Y Combinator, a seed accelerator that funds early stage start-ups  — Venture Capital firms know not every company funded will become a verb (e.g., Google or Uber) but instead look to generate solid returns for their investors from a fund that invests in a number of different companies.

VC Produced Record Returns During COVID

In the global landscape, few investments offer the outsized return potential of venture capital. In 2020, for example, the Cambridge Associates U.S. Venture Capital Index returned 50%, well above its long-term average of 32.4%, and significantly outpacing U.S. public equities, which also had a strong year.1

While these averages are high relative to traditional investments such as stocks and bonds, the VC investor is seeking anything but average returns. The VC investor is looking to gain access to the companies that will become the next dominant force in an industry, generating outsized returns that aren’t usually attainable in public markets. Most VCs build a portfolio of companies, spreading capital around knowing that some will likely outperform, and others may not achieve the desired returns.

VC investors typically realize returns through “exits” or the point where a startup gets acquired, merges with another company, or goes public through an initial public offering (IPO). At this stage, the equity stake that a VC investor has is purchased, often at a significant multiple. For example, Facebook acquired WhatsApp in 2014 for $22 billion, the largest-ever acquisition of a VC-backed company (up until then). WhatsApp had a single VC investor – a company that turned a $60 million investment into $3 billion from the acquisition.1

While exits like the WhatsApp deal aren’t routine, these are the types of deals that motivate VC investors to scour tech hubs like Silicon Valley looking for the next great company.

Unicorns Are Everywhere

A startup valued at $1 billion or more was once so rare that it was called a “unicorn.” Today, however, they’ve become more common and lost their mythical status. This year alone, the pace of startups reaching unicorn status eclipsed one per day. In the second quarter of this year alone, 136 new unicorns were born – a record.1 Unicorns are often later-stage startups with multiple rounds of financing under their belts, many of which are already household names. The largest unicorn today, by valuation, is ByteDance, the company that owns TikTok, now valued at around $140 billion. 

Because startups have access to abundant investment capital today, some investors can exit a company before it goes public or gets acquired. The capital pool allows other investors to enter and gain access to some of these later-stage opportunities on what is known as the secondary market in VC investing.

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VC Continues to Power Technology-Driven Innovation 

The promise of outsized returns is the primary reason why VC has attracted record-breaking amounts of cash in recent years. Investors seeking returns and innovators in need of startup cash often make fast friends. As the world continues to become increasingly digitized, the need for innovation has also grown. The demand created in emerging tech categories such as the Internet of Things, autonomous vehicles, and artificial intelligence drives innovation and directs more capital to tech startups. For example, in the first half of 2021, more than $50 billion was funneled to Silicon Valley startups alone – a nearly 100% increase over the same period in 2020, which was also a strong year.1 Many startups will fail, but savvy VC investors know this, which is why they hedge their bets by investing in many of them. It only takes one significant breakthrough to offset losses, which is the nature of VC investing.

 Source: 1. CB Insights, https://www.cbinsights.com/research/best-venture-capital-investments/

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