How venture capital investing works

May 8, 20234 min read
How venture capital investing works
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Venture capital (VC) is an essential building block of the economy, yet traditional portfolios do not give ordinary investors the opportunity to benefit.

After outsized returns in 2020 and 2021 — VC funds in 2020 had a 71.7% pooled internal rate of return, more than double returns from the S&P 500 (30.8%) — VC-backed businesses faced significant challenges in 2022 due to market instability, geopolitical turmoil, and recession fears. These early-stage businesses saw a 17% drop in valuations, with median and average valuations falling to their lowest point in five years. An IPO freeze led those that did manage to go public to experience a 32% drop in valuations on average.

A year of lower activity has left significant venture capital funding waiting to be deployed. This market dislocation creates an environment where investors today can gain entry to potentially lucrative companies at attractive cost bases that may generate strong risk-adjusted returns.

Understanding how VC works is the first step to deciding whether this asset class belongs in your portfolio.

What is venture capital?

Quite simply, VC is early-stage investment in new private companies and ideas that have the potential to become the next dominant force in an industry, generating returns that aren’t usually attainable in public markets. Typically, investments are made through VC funds that spread risk by investing in many different companies. It takes only a few — or even one — high-growth company in a fund to offset losses from those that don’t succeed and to deliver significant returns.

Returns are realized through “exits,” or the point at which a start-up gets acquired, merges with another company, or goes public and the VC investor sells their equity stake, often at a significant multiple. 

VC is a subset of private equity (PE), which involves buying shares of established private companies, or buying out a previously public firm that is delisted. PE usually involves buying 100% ownership of a company, or carving out an entire division of a company, while VC funds tend to buy smaller, non-controlling interests in multiple unproven companies, knowing there is a high probability that some of them may not provide any return at all.

The venture capital investment lifecycle

VC investing is broken up into funding rounds. The further into these rounds a company gets, the more confidence an investor can have that it will succeed, and the higher its valuation is likely to grow. This means the amount of growth an investor can expect to achieve at a late stage is less than if they were to come in at an earlier stage.

Pre-Seed and Seed Rounds

The Pre-Seed and Seed rounds are usually the first rounds of investment. These typically include self-funding by an entrepreneur, angel investments, or investments from VC firms.

Start-ups at this stage are almost always pre-revenue and are in the early stages of research and product development. They make for the riskiest investments, yet can provide the greatest opportunity for growth.

A famous example of an extremely successful seed investment is the $500K Peter Thiel put into the nascent Facebook in 2004 for a 10.2% stake, the majority of which he sold for more than $1B when the company went public in 2012.

Series A Round

Series A is generally the first major round of investment. Some entrepreneurs self-fund through the seed stage and begin raising VC at Series A. Companies at this stage are likely still pre-revenue; they may have just started acquiring customers but are still developing a product-market fit and continuing to develop their product.

Series A investors seek to benefit by getting into the company at a lower valuation and before shares are diluted by larger numbers of investors. The drawback, of course, is that the company faces more risk of failure at this early stage.

Series B Round

Series B companies have usually solved for product-market fit and are now gaining sales traction. Entrepreneurs in the B round seek to raise funds to scale their operations and sales and to continue product development.

These companies have typically shown some level of growth and success, making them potentially less risky and attracting more interest from other investors. However, they’re likely to have a higher valuation that makes shares more expensive, reducing the potential growth of a capital investment.

Additional funding rounds

As a company raises for Series C, it is usually more focused on executing its long-term growth plan. Series D funding and additional funding rounds are usually reserved for companies that have reached a valuation of at least $1B. These companies — so-called “unicorns” — are well-established names in their respective sectors, or perhaps even market-makers. Companies at this stage are usually pre-IPO or strong acquisition targets.

Simulation of hypothetical 1,000 startups. For illustrative purposes only.

How to invest in venture capital 

Directly investing in an individual company may be a prohibitive entry point for even an experienced investor. Properly vetting a company may require specialized knowledge of its product or market, and concentrating risk in one company could lead to greater losses. More commonly, investors access VC markets through funds. A diversified fund has stakes in many VC-backed companies. A fund of funds (FOF) is an investment in a fund that then invests in several other funds. A FOF provides the highest level of diversification, but it does subject investors to multiple layers of fees.

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