Glossary · Funds and derivatives
Venture capital
Venture capital is money invested in young startups in exchange for a share of the company, in the hope that a few of them grow into giants.
Also called: VC, startup funding, seed funding, Series A
In plain words
A startup with a clever idea and no profits cannot get a bank loan: there is nothing to repay it with. Instead it can sell a slice of itself to a venture capital fund. The fund gets shares; the startup gets money to hire people and build its product.
Most startups fail, and venture capitalists know it. They invest in many, expecting that a handful will grow so much that they pay for all the losses. One company that becomes worth a hundred times what the fund paid can make a whole fund successful.
Startups raise money in rounds as they grow: seed money first, then Series A, B, C and so on, usually at a higher value each time. The investors get paid when the company is sold to a bigger one or lists its shares in an IPO.
Example
Ten bets, one winner
- A fund puts $1 million into each of 10 startups: $10 million in all.
- Five go bust: $0. Three are sold for about what was invested: $3 million. One returns three times: $3 million.
- One becomes a big success and its stake is sold for $30 million.
- Total back: $36 million, 3.6 times the money. Without the one big winner the fund would have lost 40%.
Venture capital is a game of rare, huge wins: the question is not how many startups fail, but whether one becomes enormous.
One level deeper
A venture fund is a partnership: the venture capitalists (general partners) pick the startups and sit on their boards; pension funds, endowments and rich families (limited partners) supply most of the money. Like private equity, the fund lives about ten years and charges a yearly fee of about 2% plus around 20% of the profits.
The first modern venture firm, American Research and Development Corporation, was founded in Boston in 1946. Venture money later helped build much of Silicon Valley, from chipmakers to software, internet and AI companies.
Startups are valued at each round by what the new investors pay. Those values can rise far ahead of any profits, and fall just as fast, so they are less reliable than a stock market price that changes every second.
Why it matters
Venture capital pays for many of the new technologies that later change daily life and create whole industries (creative destruction).
Because a few winners matter so much, it is very prone to survivorship bias: we hear about the startups that became giants, not the thousands that vanished.
Its booms and busts follow interest rates and stock prices: when IPOs are easy, more money flows in.
A common mistake
Myth: Venture capitalists mostly pick winners.
In fact: Most of their investments lose money or just pay back. A fund succeeds if one or two companies grow enormously, so a good venture capitalist can be wrong most of the time.
Questions people ask
What is a unicorn?
A startup valued at $1 billion or more before it is listed on a stock exchange. The word was coined in 2013 because such companies were then rare.
What do Series A, B and C mean?
The order of funding rounds. Seed money comes first, often from founders, friends and angel investors; Series A is usually the first big round from venture funds, and each later round raises more money at a higher value, if the company is doing well.
How do venture capitalists make money?
When a startup they backed is bought by another company or lists its shares in an IPO, they can sell their stake. The managers also take a yearly fee and a share of the fund’s profits.
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About the numbers
- This page explains a term. It is not investment advice.