The moniker “venture capital” is believed to have originated from the financier John Hay Whitney. Having served in World War 2, Whitney returned to the United States with a new mission: to spread American ideals of free enterprise by supporting fledgling entrepreneurs. He distinguished his investment method from traditional private equity or investment banking by making riskier investments in new, unproven businesses with the aim of larger returns should these businesses succeed. He called this investing style “adventure capital,” eventually shortening the term to “venture capital” for marketing purposes.
What is Venture Capital?
Venture capital is a type of equity financing for early-stage, high-potential startups or companies with significant growth prospects. Capital is often deployed by venture capital funds, which raise money from investors. Venture capital funds have become increasingly specialized, often focusing on one industry or even subsector, such as software, biotechnology, or renewable energy. In addition to specialized funds, many companies now have internal venture funds that they use to make strategic investments within their industry. Venture capitalists often bring more than their checkbook; they also provide valuable guidance, mentorship, and connections to help the startup grow.
How Does It Work?
The typical venture capital investment process looks something like this:
- Pre-Seed and Seed Funding: An entrepreneur creates a product or has a new idea that needs significant upfront capital before it can be successfully commercialized. The entrepreneur then pitches her business plans to venture capitalists. If they believe the business is viable, they provide the necessary startup capital in exchange for a negotiated amount of equity in the company (which usually reflects the amount of risk the venture capitalist is taking).
- Series Funding: After receiving initial investments, the business can hire a small staff and start product development. Once there is a product, more capital may be needed to scale production or sales before the business can become self-sustaining. The business will therefore likely seek money in more funding rounds (often labeled alphabetically, so Series A, Series B, etc.).
- Exit Strategy: Venture funds are usually bound by their limited partnership agreements to return invested capital (and any gains) to their limited partners after a set number of years (often ten). Thus, venture capitalists invest with an exit strategy in mind. They garner returns when their portfolio company goes public, gets acquired, or achieves certain profitability milestones.
Why Does It Matter?
Venture capital plays a pivotal role in the modern economy for several reasons. First, they foster innovation. From the iPhone to synthetic insulin, venture funding has enabled some of the greatest leaps in human innovation in the past fifty years. To make an outsized return, venture capitalists are looking to invest in more than incremental improvements to current technology. They seek promising new technologies that address an important unmet need or dramatically boost productivity. Examples of recent venture-backed innovations include artificial intelligence, gene therapy, and green tech.
Second, venture-backed companies don’t just create technology – they also create jobs. Startups that receive venture funding tend to expand rapidly. According to a recent NCVA study, venture-backed companies “grew at roughly eight times the pace of employment at non-venture-backed companies.”
Last, venture capital contributes to overall economic growth. Many of the most valuable publicly traded companies were initially venture-backed.