What is venture capital and how does it work?

You might not realize it, but you use products and services made by companies that were initially funded by venture capital every day.

If you use Facebook, Instagram, or TikTok… If you’ve seen a movie on Netflix or Hulu… If you listen to music on Spotify or shop on Amazon… you’ve come face-to-face with a venture-funded business.

You may also notice the brands we just listed are some of the biggest companies in the world – and that’s no coincidence. Venture capital plays a significant role in a startup’s earliest stages. VC provides fledgling companies with a critical infusion of capital they can use to grow and expand into successful businesses.

In short: venture capital is a vital part of the entrepreneurial ecosystem, and a massive driver of economic growth worldwide.

Let’s explore everything you need to know about VC: its history, its role today, and exactly how it plays into the startup ecosystem you’re now part of.

What is venture capital?

Venture capital (“VC”) is a form of private equity used to finance promising startups and small businesses.

It’s a type of funding that is very different from traditional bank loans, where the borrower is expected to pay back the principal with interest. 

Instead, venture capitalists typically receive equity – or a financial stake in the business – in exchange for their capital, betting on the company's success over a long-term horizon of 6-10 years on average.

Because VCs invest in early-stage companies, each individual investment carries significant risk. That risk is can be potentially minimized by investing in dozens or even hundreds of offerings – and studies show that the top quartile of VC funds can produce annualized returns nearly three times greater than the S&P 500.

That’s exactly why so many of America’s greatest fortunes were built, at least in part, on venture investments. (The Rockefellers, Mellons, and Rothschilds were all well-known for investing in startups.)

Let’s dig into venture capital’s colorful history and the impact this industry has had on our economy and culture.

The history of venture capital

Venture capital has its roots in the post-World War II era when many soldiers returned home from war and used their GI Bill benefits to attend college. 

During this time, a new breed of entrepreneur emerged—one who was not content with working for someone else and instead wanted to strike out on his own. 

These entrepreneurs needed capital to start their businesses, but banks were unwilling to take on the risk of lending to them. That's where venture capitalists came in. 

In 1946, MIT president Karl Compton, Massachusetts Investors Trust chairman Merrill Griswold, Federal Reserve Bank of Boston president Ralph Flanders, and Harvard Business School professor General Georges F. Doriot (the "father of venture capital”) formed the first modern VC firm: the American Research and Development Corporation (ARDC).

ARDC is credited with the first major venture capital success story. In 1957, the firm invested $70,000 for a 70% stake in DEC (Digital Equipment Corporation), a computing company that went public in 1966 at a market cap of over $355 million. ARDC’s investment grew by more than 350,000%.

Since then, the VC industry has grown to include thousands of firms worldwide, including household names like Sequoia Capital, Andreessen Horowitz, Kleiner Perkins, and many others.

The 1990s were a prosperous time for the industry, up until the dot-com bubble burst in the early 2000s. During this time, VC funds that were overly invested in the tech sector (which the majority were) suffered severe losses. However, the “bubble” served as a much-needed recalibration for the VC industry, which had been recklessly pumping capital into startups at massively inflated valuations.

Since then, the industry has experienced steady growth; 2021 was a record-breaking year for venture capital, with firms deploying $329 billion into more than 17,000 deals in the U.S. alone.

Total assets under management (AUM) for VC firms also reached a record high last year. 

In the United States alone, venture capital firms’ assets reached $995 billion at the end of 2021, including $222 billion in dry powder–capital that’s been committed to a VC fund, but not yet deployed into any investments. These assets were managed by 2,889 firms and 5,338 funds. 

Clearly, these VC funds make up a massive repository of wealth. Before we talk about why that’s so important, let’s go over exactly what VCs are… and what they do with all that capital.

What are venture capital funds?

There are many different forms venture capital can take, but typically, it works like this:

• A venture capital firm pools investment capital from a variety of sources, like family offices, high-net-worth individuals, and institutions.

• That pooled capital is called a venture capital fund. Managed by the firm, this VC fund typically has specific criteria and goals outlined for the deployment of all that money. (On average, a single VC fund contains $100-200 million.)

• Over the course of months or years, the venture capitalists in charge of the fund use that capital to buy equity stakes in a portfolio of companies – between 30 and 80 on average.

• The fund makes a return on investment if and when its portfolio companies have exit events (also known as liquidity events); mergers, acquisitions, and IPOs are the most common.

Every VC fund is managed by a general partner, whose duties include:

• Raising money

• Selecting investments

• Supervising operational, accounting, and legal facets of the fund

VC fund investors are called limited partners. These are typically high-net-worth investors or institutions, like pension funds and foundations, that seek the potentially outsized returns these funds are capable of producing.

What’s the difference between angel investors and venture capitalists?

An angel investor is an individual who invests their own capital into startups and small businesses.

When most people think of angel investors, they probably think of business tycoons capable of writing a $50,000 check on the spot. Historically, for the most part, that’s been a fairly reasonable assumption; until just a few years ago, only accredited investors were legally allowed to invest in private companies. In other words, unless you had $1 million in the bank, made $200k or more a year consistently, or had special certifications, startup investments were completely off the table for you.

The 2016 JOBS Act changed all that and opened the doors for almost anyone to become an angel investor. Today, it’s possible to invest in a startup for just $50 or $100–no special certification required.

There are two main differences between angel investors and VCs. First, angel investors commit their own money, while VCs pool capital from other sources and then deploy it. Second, angels typically get involved earlier in a startup’s story, when less capital is needed to fuel growth. VCs, on the other hand, often invest later on, with check sizes in the millions of dollars. Finally, private equity (PE) firms make even bigger deals than VCs.

What's the difference between venture capital and private equity (PE) firms?

Venture capital and private equity firms have a lot of similarities, so it’s important to first understand how they are alike before we explore how they are different.

Along with hedge funds and real estate, private equity and venture capital firms operate in the private markets, where most investments are illiquid (meaning they can’t be bought and sold at any time like stocks).

Both private equity and venture capital firms raise pools of capital from accredited investors in order to invest in privately-owned companies. Their goals are the same: to increase the value of the company by improving operations, restructuring the business, or selling it to a larger company.

PE and VC primarily differ from each other in the following ways:

• The types of companies they invest in

• The levels of capital invested

• The amount of equity they obtain through their investments

• When they get involved during a company's life cycle

PEs often take a majority stake (50% ownership or more) in mature, established companies operating in traditional industries. 

They usually invest in businesses that are deteriorating (distressed) due to operational inefficiencies. They make money by correcting those inefficiencies and making the company profitable again. 

By contrast, venture capital firms fund and mentor nascent, often tech-focused companies that show potential signs of rapid growth. 

Opposite from PE firms, VC firms provide funding in exchange for a minority stake of equity—less than 50% ownership.

Let’s take a closer look at how venture capital firms invest and make money.

How venture capital works

Once a VC fund is full of capital commitments, the general partner of the fund will start to deploy that capital. Typically, it’s used to fund a variety of investments, including seed funding for early-stage companies, venture rounds for more mature startups, and “buyouts” – the act of purchasing another firm or investor’s existing stake in a business.

VCs typically invest in companies that are in the early stages of development and have a high potential for growth. This means that they are often taking on a higher risk than other types of investors, but the potential rewards are much greater.

One of the most important things to understand about venture capital is that it is a long-term investment. VCs are not looking to make a quick buck; they are looking to invest in companies that will grow and succeed over the long haul. Most funds have a goal timeline of 10 years.

Venture capital funds typically have diverse portfolios of investments. That’s because:

• Private equity is a “hits business” – meaning that the best performers in a portfolio typically make or break the fund’s overall returns

• By investing in startups at various stages, VCs can increase the chances of having at least some of their investments generate returns in just a few years, while others may take 10 or more

• Diversification can help hedge against market swings and other unforeseen shifts that may take down some of their portfolio companies

While VCs provide a critical source of funding for startups, it's important to remember that they are also running a business. Their goal is to make money, and they expect to see a return on their investment. 

This means that VCs will typically only invest in companies that have the potential to scale, or grow, quickly and sustainably. If a company is not meeting these expectations, the VC firm may choose to sell its stake or even force the company to shut down.

The goal, of course, is the opposite. For many companies, that infusion of VC capital is exactly what they need to fuel growth and expansion and make it to their next stage of funding.

Here’s what we mean by that.

The venture capital funding life cycle

No two startups are exactly the same, and neither are their funding journeys. However, most startups that secure venture funding follow a similar life cycle, with new rounds of financing happening at each stage of growth.

Brand new startups are usually funded by the founders themselves, also known as “bootstrapping.” Think Mark Zuckerberg in his dorm room, coding out the first MVP (minimum viable product) of Facebook.

Some startups also have a “friends and family round,” during which people in their inner circle have the opportunity to show their support by investing.

Once the idea behind the company starts to take shape, most founders need to start raising capital to keep things going. This is known as the seed stage.

Seed stage

This is often a company’s first official round of funding. It’s the “setup phase” when entrepreneurs pursue seed money from angel investors or venture capitalists to fund their idea. 

For most founders, that means they have to do a lot of pitching. Seed funding is as early as it gets; sometimes, a founder is asking for money just to figure out if their idea is viable to begin with. That can be an incredibly risky bet for an angel investor to take—but if it pays off—it’s also the funding round with the most growth potential.

Today, most entrepreneurs can’t get away with pitching “just an idea,” unless they have an impressive track record of building successful companies or some other traction to show. (For reference: startups that raise their seed rounds on Republic all have either revenue on the books or some other indication of traction—like VC backing or a huge community.)

Seed rounds are fairly small, ranging from $1-4M on average. Most often, this capital is used for things like product development, market research, and making initial hires. 

Early VC stages

After a startup raises seed money and demonstrates the viability of its product or idea, most founders start looking for VC funding.

By this point, the company has usually finished developing the product or service and taken it to market. This is when investors get their first look at how well the product compares to its competitors.

VC-led funding rounds are named alphabetically, starting with Series A. Funding at this stage tends to be higher than prior stages; is often earmarked for things like manufacturing, sales, and marketing.

In an ideal scenario, a startup that raises Series A funding will come back to raise a new round—their Series B—at a higher valuation than before. To do this, a company needs to demonstrate revenue growth or other traction that justifies the business is worth more.

This is an opportunity for the startup to be battle-tested; to see if they can hold their own against the competition. If they can, most VC firms will greenlight them for the next stage.

Expansion stage, or late VC stage

Companies that make it to late-stage VC rounds are typically large and well-established. They may be valued at hundreds of millions, or even billions, of dollars. At this point, the business should have a clear “product-market fit” for its product or service.

It’s important to note that not all companies will make it to Series C financing (or D, or E, or any others). Some startups do fail, even after receiving millions of dollars in their Series A or Series B rounds. Others may get acquired by larger companies that want their product, team, or intellectual property. 

There’s also the possibility that a startup won’t need late-stage VC financing. This can happen if a company achieves profitability early, and can funnel those profits back into the business instead.

For VC firms, there are a few preferred outcomes, or exits, for their portfolio companies. The main ones are:

• Growth and multiple rounds of follow-on funding, followed by an initial public offering (IPO) or direct listing

• An acquisition or merger with another company at a higher valuation than VCs invested at

• A company becoming profitable and self-sufficient enough to buy back the firm’s stake at a higher price than they paid for it.

2021 was a breakout year for exits in the venture capital space. Of the $774.1 billion in exit activity, a staggering $681.5 billion (88%) came from IPOs and SPACs (public listings)—representing a 168.0% YoY growth.

This proliferation of exits included 296 VC-backed public listings representing YoY growth of 114.5%, led by the notable IPOs of Rivian, Aurora, and Gitlab.

Any of these outcomes qualify as “liquidity events,” meaning that they allow investors to cash out of their stake in the business.

For angel investors, that return on investment can be as simple as “money out vs. money in.” An angel might invest at a $10 million valuation, see that startup get acquired for a $20 million price tag, and get essentially double their money back.

For VC funds, it’s a bit more complicated.

How do venture capital firms make money?

Venture capital funds generate revenue from two sources: management fees and carried interest, or carry, from the portfolio’s returns.

These fees may vary depending on the fund, but the typical structure follows something called the “2-and-20” rule, which is explained below:

Management fees

Management fees are a fixed percentage of the fund’s total assets under management (AUM). In the 2-and-20 model, that management fee is 2%. So, if a VC firm were to raise a $100 million fund, it would make 2% of that–or $2 million–in management fees charged to its investors (or limited partners). That fee is normally charged annually until the fund is closed. It’s used to cover daily expenses and overhead while the fund’s portfolio matures.

Carried interest, or “carry”

Carry is the percentage of a fund’s overall profits that go back to the VC firm in the event of a return. In the 2-and-20 model, carry is set at 20%. Let’s go back to that last example of a $100 million VC fund. Hypothetically, if that same fund was worth $200 million after exiting its portfolio companies, the carry paid to the VC firm would be $20 million ($200 million value – $100 million original investment = $100 million in profits X 20%). The remaining $80 million in profits would then be distributed among the fund’s limited partners.

Carry is typically a much larger source of income for venture capital firms than management fees–which is part of what makes venture capital so competitive. Simply put, fund managers can make a lot more money when their portfolios perform better.

Why is venture capital important?

Venture capital funds are more than just an ATM for nascent companies. Aside from financing, most VCs take an active role in helping these businesses realize their full potential.

Some of the ways they help include:

Mentoring

“The first rule of venture capitalism is hands-on experience. You have to get your hands dirty.”

— Vinod Khosla

Venture capitalists are known to take a hands-on approach when working with their founders. This makes sense, since the majority of them are new to entrepreneurship and often need someone to guide them through the process of becoming a successful leader.

One of the most common moves a firm makes is to appoint a member of their team to the board of a startup. From the inside, the member has a say in the company’s decisions, and can assist with building strategies and technical resources in order to help the business succeed.

Leveraging professional networks

Venture capitalists are often former successful entrepreneurs with large rolodexes of contacts that they frequently tap into to help their portfolio companies grow. They often rely on their professional network of entrepreneurs, investment bankers, M&A lawyers, LPs, and others they’ve worked with in growing and selling startups.

Ongoing Funding

When a VC invests in a startup, they’re often providing an infusion of capital that is desperately needed in order for that company to continue operations and growth. Without venture capital, most businesses wouldn’t be able to survive those early years.

But that commitment doesn’t have to end with the first check. Most VCs will continue to invest in a startup’s follow-on financing rounds, as long as they feel the company is moving in the right direction. On top of that, when a startup has a well-known VC at the cap table, other investors often follow suit–helping companies fill their funding rounds faster.

How does venture capital impact everyday investors?

If you’ve ever invested in a startup, you’re officially part of an ecosystem that relies heavily on venture capital.

Some of the companies that raise capital on Republic will go on to receive funding from VCs at later stages. When that happens, it’s usually a good thing. Remember, most of the time, VCs back startups that are more mature and have higher valuations than they had when angel investors got in. Venture backing is usually a sign of traction and growth.

Still, the JOBS Act has turned many traditional pathways to growth on their heads. Less than a decade ago, nonaccredited investors could not invest as easily in private companies as they can today. 

That’s no longer the case—and, it’s had a tremendous impact on the VC industry as a whole. Today, startups can raise up to $5 million from nonaccredited investors via Regulation CF (crowdfunding)... which means many no longer need to spend months pitching to accredited angels or begging VC firms for support just to get off the ground.

That’s because Reg. CF isn’t solely a way to raise money–it’s also a way to spread brand awareness and potentially amass an army of brand ambassadors and new customers. 

This is still an evolving space, and we have yet to see the full impacts equity crowdfunding will have on venture capital. At Republic, our vision is a future in which anyone can invest in anything, from anywhere in the world–and we believe equity crowdfunding was just the first exciting step towards that future.

Want to join the financial revolution?