How Venture Capital Works

Every startup founder has heard of venture capital, but do you know how it works?

April 30th, 2019   |    By: The Startups Team

If you’ve been in the startup world for more than five minutes, you’ve heard the term “venture capital.” Maybe you even know founders who have raised VC money themselves. But you might be wondering: How does venture capital work?

What is venture capital?

Venture capital is financing that’s invested in startups and small businesses that are usually high risk, but also have the potential for exponential growth.

The goal of a venture capital investment is a very high return for the venture capital firm, usually in the form of an acquisition of the startup or an IPO.

How does venture capital work?

A venture capital firm is usually run by a handful of partners who have raised a large sum of money from a group of limited partners (LPs) to invest on their behalf. VCs are only interested in companies that can have a massive outcome (think "billions") in a very short period of time (think "tech startups"). The way a VC works is that they have 10 years or less to invest and return most of the capital they have raised, so they can only make investments in the fastest growing, high output companies. If you can't show that you can grow to $100 million in 4 years, you're less attractive to most VCs. If you can, rest assured, you'll wind up in their conference room.

The LPs are typically large institutions, like a State Teachers Retirement System or a university who are using the services of the VC to help generate big returns on their money. The partners have a window of 7 to 10 years with which to make investments, and more importantly, generate a big return. Creating a big return in such a short span of time means that VCs must invest in deals that have a giant outcome.

These big outcomes not only provide great returns to the fund, they also help cover the losses of the high number of failures that high risk investing attracts.

VCs typically invest once companies have already taken on money from angel investors since they use Angels to vet deals and see some traction before they get involved.

Venture capital firms make a small number of investments

Although venture capital firms have large sums of money, they typically invest that capital in a relatively small number of deals. It may surprise you to know VCs only write about 1,000 new checks per year so while those checks are typically larger ($2 million to $100 million) they are far less frequent.

It’s not uncommon for a VC with $100 million of capital to manage less than 30 investments in the entire lifetime of their fund. The reason for this is that once each investment is made, the partners must personally manage that investment for up to 10 years. While money is often plentiful, the VC’s time is very limited.

With such a small number of investments to make, VCs tend to be very selective in the type of deals they do, typically placing just a few bets each year.

Regardless, they still may see thousands of entrepreneurs in a given year, making the probability that an entrepreneur will be the lucky recipient of a big check pretty small.

The most common check written by a venture capital firm is around $5 million and is considered a “Series A” investment. It’s relatively uncommon for these checks to be the first capital into a startup.

Most startups begin with finding money from friends and family, then angel investors, and then a venture capital firm.

Depending on the size of the firm, VCs may write checks as little as $250,000 and as much as $100 million.

The smaller checks are typically the domain of angel investors, so VCs will only go into smaller sums when they feel there is a compelling reason to get in early at a startup company.

Favored industries for venture capital

Venture capitalists also tend to migrate toward certain industries or trends that are more likely to yield a big return. That’s why it’s common see so much venture capital and angel investment activity around technology companies: They have the potential to be a huge win.

VCs know that for every 20 investments they make, only one will likely be a huge win. A win for a VC is either one of two outcomes – the company they invested in goes public or is sold for a large amount.

VCs need these big returns because the other 19 investments they make may be a total loss. The problem, of course, is that the VCs have no idea which of the 20 investments will be a home run, so they have to bet on companies that all have the potential to be the next Google.

Conversely, other types of industries may yield great businesses, but not giant returns. A landscaping business, for example, may be wildly successful and profitable, but it’s not likely to generate the massive return on investment that a VC needs to make it’s fund work.

The other reason VCs tend to invest in a few industries is because that’s where their domain expertise is the strongest.

It would be difficult for anyone to make a multi-million dollar decision on a restaurant if all they have ever known were microchips. When it comes to big dollar investing, VCs tend to go with what they know.

Unlike a bank that takes all interested customers, VCs tend to be far more selective in who they take pitches from.

Often these relationships are based on other professionals in their network, such as angel investors who have made smaller investments in the company at an early stage, or entrepreneurs whom they may have funded in the past.

Investing in the entrepreneur

A popular phrase among venture capitalists is “I don’t bet on the horse, I bet on the jockey.” Don’t worry, in this case they aren’t calling you the horse!

The entrepreneur’s track record is incredibly important in evaluating a venture capital group’s decision to invest. Demonstrating your past achievements is a fantastic way to give a venture firm confidence that you’ll be successful in the future. In many ways it mirrors the way employers look at your resume in order to see if you are qualified for a job.

That’s often why you’ll see venture capital groups give checks to companies they would never normally invest in – they believe so strongly in the entrepreneur.

And that’s the key – the venture capital group strongly believing in you. If they like you and the idea is so-so, there may be a deal. But if they like the idea and think you’re not someone they would want to back personally, the deal is almost certainly dead.

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Profile of a venture capitalist

Amongst venture capitalists, titles matter. It’s not due to ego (although it does come into play), it’s due to decision-making authority, which matters to you as the entrepreneur.

While there are a handful of titles that are thrown around, such as General Partner and Principal, what matters the most is that you talk to a “Partner.”

Venture capital firms are setup as partnerships, with each partner typically getting a vote in whether a new investment is made. Structures differ a bit from venture firm to firm, but many require a unanimous vote in order to make an investment decision.

For this reason, unless you’re getting buy-in at the partner level, you’re not over the goal line.

The different roles in a venture capital firm

When you’re trying to figure out how venture capital works, it’s important to know the different roles in a venture capital firm.

Associates

Associates are the entry level candidates at a venture capital firm. Since there are very few firms, these jobs tend to be highly coveted, so even an entry level Associate will tend to be pretty polished.

Entrepreneurs often get excited when a venture capital firm makes an unsolicited call asking about their business. They immediately assume that the firm is interested in making an investment. The truth is it’s more likely that an associate is looking to drum up new business.

Generally speaking, if you’re getting an unsolicited call from a venture capitalist, it’s from an associate of the firm. The first question you should politely ask is “What is your role at the firm?” If they don’t use the word “partner,” it’s most likely because they aren’t one. Partners at VC firms usually make it very clear they are partners. Everyone else dodges the question.

The Golden Key: A Partner

Within the land of venture capital giants, the partner reigns supreme.

The partner has the ability to endorse your deal to his partnership, which is exactly the goal of all of your pitch meetings. The partner is the person who will most likely join your board. When things go really well or really horribly, this is specifically the person that you’re going to be married to through the entire ride.

Finding the right fit is more than just “anyone that will write a check” because in fact any venture capital firm can write a check. The right fit is a specific partner that truly understands and believes in your business and will go to bat for you when you really need it.

Other funding sources

Don’t miss our guides to the full range of startup funding options, below.

Federal Government Grants for Small Business: What You Need to Know

Venture Capital: What It Is & Why Use It

Series A, B, C, D, and E Funding: How It Works

What is Crowdfunding?

Types of Crowdfunding: Donation, Rewards, and Equity-Based

Private Investors for Startups: Everything You Need to Know

Convertible Notes (aka Convertible Debt): The Complete Guide

Small Business Startup Loans: What You Need to Know

About the Author

The Startups Team

Startups is the world's largest startup platform, helping over 1 million startup companies find customers, funding, mentors, and world-class education.

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