What Is a Venture Capitalist?
A venture capitalist (VC) is a private equity investor that provides capital to companies with high growth potential in exchange for an equity stake. A VC investment could involve funding startup ventures or supporting small companies that wish to expand but have no access to the equities markets.
Key Takeaways
- A venture capitalist (VC) is an investor who provides young companies with capital in exchange for equity.
- Startups often turn to VCs for funding to scale and commercialize their products.
- Due to the uncertainties of investing in unproven companies, venture capitalists tend to experience high rates of failure.
- However, the rewards are substantial for those investments that do pan out.
- Some of the most well-known venture capitalists are Jim Breyer, an early investor in Facebook, and Peter Fenton, an investor in X (formerly Twitter).
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Understanding Venture Capitalists
Venture capitalist firms are usually formed as limited partnerships (LPs) where the partners invest in the VC fund. A committee is usually tasked with making investment decisions. Once those promising emerging growth companies are identified, the pooled investor capital is deployed to fund these companies in exchange for a sizable equity stake.
Contrary to common belief, VCs do not normally fund a startup at its outset. Instead, VCs seek to target firms bringing in revenue and looking for more money to commercialize their ideas. The VC fund will buy a stake in these firms, nurture their growth, and look to cash out with a substantial return on investment (ROI).
Venture capitalists typically look for companies with a strong management team, a large potential market, and a unique product or service with a strong competitive advantage. They also look for opportunities in industries that they are familiar with, as well as the chance to own a large percentage of the company so that they can influence its direction.
VC firms control a pool of various investors' money, unlike angel investors, who use their own money.
VCs are willing to risk investing in such companies because they can earn a massive return on their investments if they are successful. However, VCs experience high rates of failure due to the uncertainty involved with new and unproven companies.
Venture Capital Structure
Wealthy individuals, insurance companies, pension funds, foundations, and corporate pension funds may pool money in a fund to be controlled by a VC firm. The venture capital firm is the general partner (GP), while the other companies/individuals are limited partners (LP). All partners have part ownership of the fund.
The general structure of the roles within a venture capital firm varies among firms, but they can be broken down into roughly three positions:
- Associates: These individuals usually come to VC firms with experience in either business consulting or finance and, sometimes, degrees in business. They tend to do more analytical work, analyzing business models, industry trends, and sectors. They also work with the companies in a firm's portfolio. Although they do not make key decisions, associates may introduce promising companies to the firm's upper management.
- Principals: A principal is a mid-level professional. They usually serve on the boards of portfolio companies and ensure that they operate without major hiccups. Principals are also in charge of identifying investment opportunities for VC firms and negotiating terms for both acquisition and exit. Principals are on a "partner track"that depends on the returns they can generate from the deals they make.
- Partners: The higher profile partners primarily identify areas or specific businesses to invest in, approve deals (whether investments or exits), occasionally sit on the board of portfolio companies, and generally represent their VC firms.
The VC firm, as the GP, controls where the money is invested. Investments are usually in businesses or ventures that most banks or capital markets avoid due to the high degree of risk.
Venture capitalists must follow regulations as they conduct their business. Private equity firms and venture capitalists fall under U.S. Securities and Exchange Commission (SEC) regulatory control. Banks and other financial institutions must follow anti-money laundering regulations.
Venture capital fund managers are paid management fees and carried interest. Depending on the firm, roughly 20% of the profits are paid to the company managing the private equity fund, while the rest goes to the limited partners who invested in the fund. General partners are usually due an additional 2% fee.
History of Venture Capital
The first venture capital firmsin the U.S. started in the mid-twentieth century. Georges Doriot, a Frenchman who moved to the U.S. to get a business degree, became an instructor at Harvard's business school and worked at an investment bank. In 1946, he became president of American Research and Development Corporation (ARDC), the first publicly funded venture capital firm.
ARDC was remarkable in that, for the first time, a startup could raise money from private sources other than wealthy families. Previously, new companies looked to families such as the Rockefellers or Vanderbilts for the capital they needed to grow. ARDC soon had millions in its account from educational institutions and insurers.Firms such as Morgan Holland Venturesand Greylock Partners were founded by ARDC alums.
Startup financing began to resemble the modern-day venture capital industry after the passing of the Investment Act of 1958. The act enabled small business investment companies to be licensed by the Small Business Administration (established five years earlier).
Venture capital, by its nature, invests in new businesses with great growth potential (but also an amount of risk substantial enough to scare off lending by banks).Fairchild Semiconductor (FCS),one of the earliest and most successful semiconductor companies, was the first venture capital-backed startup, setting a pattern for venture capital's close relationship with emerging technologies in the San Francisco Bay Area.
Venture capital firms in that region and period also established the standards of practice used today. They set up limited partnerships to hold investments, with professionals acting as general partners. Those supplying the capital would serve as passive partners with more limited control. The number of independent venture capital firms increased in the following decade, prompting the founding of the National Venture Capital Association in 1973.
Venture capital has since grown into a hundred-billion-dollar industry. Today, well-known venture capitalists include Jim Breyer, an early Facebook (META)investor,Peter Fenton,an early investor in X,and Peter Thiel, the co-founder of PayPal (PYPL).
$348 billion
The record-setting value of all U.S. venture capital investments in 2021. The following two years posted other impressive figures, with 2022 venture capital activity valued at $242.2 billion and total capital in 2023 at $170.6.
How Are Venture Capitalist Firms Structured?
VC firms typically control a pool of funds collected from wealthy individuals, insurance companies, pension funds, and other institutional investors. Although all of the partners have partial ownership of the fund, the VC firm decides how the monies will be invested. Investments are usually made in businesses with attractive growth potential that are considered too risky for banks or capital markets. The venture capital firm is referred to as the general partner, and the other financiers are referred to as limited partners.
How Are Venture Capitalists Compensated?
Venture capitalists make money from the carried interest of their investments, as well as management fees. Most VC firms collect about 20% of the profits from the private equity fund, while the rest goes to their limited partners. General partners may also collect an additional 2% fee.
What Are the Prominent Roles in a VC Firm?
Each VC fund is different, but their roles can be divided into roughly three positions: associate, principal, and partner. As the most junior role, associates are usually involved in analytical work, but they may also help introduce new prospects to the firm. Principals are higher-level and more closely involved in the operations of the VC firm's portfolio companies. At the highest tier, partners are primarily focused on identifying specific businesses or market areas to invest in and approving new investments or exits.
The Bottom Line
Venture capitalists are investors who form limited partnerships to pool investment funds. They use that money to fund startup companies in return for equity stakes in those companies. VCs usually make their investments after a startup has been bringing in revenue rather than in its initial stage.
VC investments can be vital to startups because their business concepts are typically unproven and, thus, they pose too much risk for traditional providers of funding.
