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What is Venture Capital?

By Aria Krumwiede on September 1, 2021
Categories: EXECUTIVE COMPENSATION, INVESTING

High net worth individuals and institutional investors directly invest in private companies with the hopes of earning higher returns than they otherwise would in public markets. However, it’s not without taking on a significant amount of risk. Whether you are interested in investing in venture capital or are simply curious about what it is, you’ve come to the right place. Find out what it means to invest in venture capital, what the various series of funding rounds are, and what types of risks are involved with investing in venture capital here.

What is venture capital?

Venture capital is a type of long-term investment focused on buying equity in startup businesses. These companies are not publicly listed, although the goal is to achieve an exit strategy (whether it’s through a merger, acquisition, or IPO). As a comparison to private equity, investing in venture capital is perceived to carry more risk, given the portfolio companies are typically in their early stages with minimal track records.

Structure of venture capital

In the context of venture capital, the structure includes general partners (who identify investable startups and help them to work towards an exit strategy) and limited partners (which are the external investors). Investors must sign a limited partnership agreement that outlines facts such as the fund’s time horizon, how much risk each party is subject to, and the applicable fees.

Each type of partner has its own financial risk and responsibility. Limited partners are liable for however much they invest. General partners are liable for much more. For example, in case of a failure, the general partners can be responsible for repaying any debts owed by the fund.

Series of funding rounds

Startup companies raise capital through a series of funding rounds.

Pre-seed funding

The pre-seed funding round usually takes place before any venture capital financing is secured. The startup is in its earliest stages at this point, likely bootstrapping with just founders’ cash or funds from family and friends. The company is just beginning to launch with no formal proof of concept yet.

Seed funding

Once the company launches from its pre-seed stage to seek external capital, it enters the seed funding stage. Researching the market and developing the product are core activities in this stage. Most startups use this initial seed round to hire a team to continue the company’s build-out. While it’s certainly possible for venture capital firms to invest at this point, it’s more likely for angel investors to be the ones to put cash on the line in exchange for equity. An angel investor may invest as little as $25,000 or up to $500,000+.

Series A

As the seed funding ends, startups begin working towards their next milestone in order to raise a Series A round of funds. At this point, they will have some established track record to present to potential investors, such as venture capital firms. As of June 2021, the average funding amount in a Series A round is ~$19.6 million and the average valuation of a company at this stage is ~$24 million.1

Series B

The next round of funding is meant to scale the company for growth. At this stage, existing investors may invest more, additional investors may be brought on, and new venture capital firms may also look to invest in this stage. These venture capital firms can add a useful level of experience and expertise to accelerate the company’s exit goals. The average company valuation for a Series B round is between ~$30 million and ~$60 million, with the average fundraising amount at ~$33 million.  Capital raised during this stage is used to hire more talent, increase sales, market the product, and provide customer support.

Series C

In a Series C funding round, companies are looking to either expand or begin acquiring other companies. By this point, the company has a well-established track record and private equity firms, hedge funds, and other types of institutional investors may be interested to invest in this round.

Key Risks

Illiquidity

It’s important to be mindful of the illiquidity associated with investing in venture capital. You likely won’t realize any measure of return until an exit takes place (whether through a merger, acquisition, or IPO). In some cases, you may have the opportunity to sell your shares through a secondary sale, but this is not guaranteed. Further, the startup may require first right of refusal, in which investors who want to sell shares before an exit must first offer to sell shares back to the company.

High failure rate

Studies estimate that 90% of startups fail.2 However, and perhaps surprisingly, only 10% fail within the first year. The vast majority (70%) fail during years two through five. Startups typically fail due to misreading market demand, competition, and cash flow issues. The high failure rate associated with startups places a great amount of risk on investors who invest in these companies.

Bottom line

There are key considerations of risk when it comes to investing in venture capital. Speak with your financial advisor to further evaluate venture capital as an investment vehicle. Ready for some professional guidance on venture capital? Contact Dowling & Yahnke today.

 

1) https://www.fundz.net/what-is-series-a-funding-series-b-funding-and-more#intro
2)https://www.embroker.com/blog/startup-statistics/

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