5 Commonly Asked Questions About Venture Capital

Venture Capital Explained

Venture Capital (VC) is a type of business financing typically focused on startups and small businesses that have significant growth opportunities early in their lifecycle.  These investments are high-risk but also can provide substantial investment returns.

In this article, we'll explore the role of venture capitalists, the differences between venture capital and private equity (PE), the various stages of venture capital investment, and the success stories that have emerged from this dynamic industry.

1. What Is Venture Capital?

• Venture capital is a kind of financing available to high-growth potential startups and small businesses in their early stage to make it big in the business world. It is a high-risk, high return investment opportunity for venture capitalists.

2. Who Is a “Venture Capitalist”?

• Traditionally, a venture capitalist is a high-net-worth induvial who has excess savings and expertise in a specific area of business. The VC space has expanded over the years such that much of the funding is from professional fund investors. These funds often provide greater scale and diversification to investors. Portfolio companies will have access to strategic advice and operational guidance from the fund owners.

3. What Is the Difference Between Venture Capital (VC) and Private Equity (PE)?

Venture capital and private equity share many similarities, the biggest being both types of investment focus on private companies. However, there are significant differences in the types of companies they target.

• VC investors target young firms early in their lifecycle.
• PE investors typically seek established companies with existing revenue and earnings.

• VC investors usually make targeted investments, often less than $10m.
• PE firms will often focus on larger investments in excess of $100m.

• VC focuses on new private firms with strong growth opportunities.
• PE firms typically focus on mature companies that may need to be reorganized or infused with new management. These can be both public and private.

• VC investors usually take minority stakes in firms.
• PE investors typically desire to own entire companies.

4. What Are the Different VC Stages?

Seed Money (Friends and Family)

• Historically, funding at this stage was often provided by “friends and family.” This is often more of an idea than a functioning company. Research and development are a focus to create a commercially viable product. This stage is characterized by negative cash flow and a high cash burn rate, which causes many companies to fail to launch. Seed capital must provide adequate liquidity to allow new companies to grow from an idea to proof-of-concept with a viable path forward. In addition to friends and family, seed financing can be provided by accelerators, angel investors, and corporate seed funding programs.

Series A, B, C: Companies with Proof of Concept and Feasible Business Opportunities

• Series A: Series A is the first stage after seed funding. This is sometimes referred to as early-stage investing. The focus at this stage is companies that have demonstrated a demand for their products with growing sales and users. This round aims to complete product development and refine the offering. Companies begin to scale a business for greater growth by investing in talent. Professional VC investment funds often provide Series A financing.
• Series B – Growth: Companies at this point have developed an established business. Sales are growing with a need to increase the business development's scale and scope. Series B financing is often significantly larger than the prior round.
• Series C – Scale: Companies at this stage have created a successful product or service with a clear path for growth. Management at this stage is often focused on increasing scale and the scope of potential business opportunities. Historically, Series C was often the last financing stage before an IPO or acquisition. Certain companies have elected to stay private recently, creating Series D or E rounds. These can be a positive development if new markets have opened that require financing to take advantage. However, if it is a “down round,” companies raise money at a valuation less than a prior round, often due to adverse business conditions. This can create a challenging path forward for these companies.

Stages of Venture Capital Investing

Source: Cardullo (1999), "Financing innovative SMEs in a global economy" (2004).

5. Is VC Right for My Portfolio?

Venture capital was traditionally exclusively offered to large institutions or ultra-high-net-worth individuals. In recent years, VC access has been democratized, with more accessible minimums, better terms, and increased liquidity. The historical returns produced by VC have been strong, with many well-known firms organically financed using VC dollars. The additional return provided by the space does come with additional risks. These companies typically have limited revenues with no earnings. The failure rate of VC-backed companies is significant. Often, 30%-40% fail.^[1] Investors in VC can expect another 40%-50% of firms to break even on their investments. This leaves only 10%-20% of VC investments that will produce substantial returns. These success stories can create such large returns that they offset unsuccessful investments. VC investors expect returns of 25%-35% annually during the life of the investment.^[2] Research has shown that institutional portfolios with greater VC exposure have produced stronger returns.

Institutions with Large Private Investment (PI) Allocations Have Often Outperformed

"Unsurprisingly, some of the best-performing institutional portfolios maintain large PI allocations. For the ten years ending June 30, 2020, the median return for institutions with a PI allocation of 30% or more outperformed those with an allocation of 10% or less by 200 basis points (bps). Further, the median return of the highest PI allocators was higher than the top return of those investors with PI allocations less than 10%. The differences are even more dramatic when looking at VC alone. The median return for those investors with a 15% or greater allocation to VC was 300 bps higher than the median return of those investors with VC allocations less than 5%."^[1]

VC should be considered an “alternative investment” within a portfolio context. There are numerous considerations when adding alternative investments. Typical allocations to the alternative space can range from 10-25% of overall portfolio weightings. This weighting should include different types of investments, including real estate, hedge funds, private equity & credit, and venture capital. VC can be amongst the most lucrative investments in the investment world.

Data from Cambridge Associates shows that investments made by top-quartile VC firms in early-stage companies produced an average internal rate of return (IRR) of over 25% over the last 25 years, performing about 2.5x as well as the public market equivalents over the same time period.^[2][3]

However, VC is also associated with high rates of failure. VC is typically not liquid, and investors need to be able to maintain their investments for several years. Due to the risks involved, VC allocations tend to be a smaller portion of an investor’s allocation. In addition, it is important to invest in a diversified manner. VC investors must be prepared that many portfolio companies will not survive. Investing in a fund can mitigate the impact of a single company’s failure and increase the likelihood of gaining exposure to a successful company. The exposure to a single successful portfolio company can offset losses on other investments. Numerous household names were seeded and grew profitable by working with VC firms.

VC Success Stories

Google is one of the best-known and most profitable companies in the world. Sequoia Capital and Kleiner Perkins, two of the most successful VC firms, invested $25 million in 1999. These funds earned enormous returns when Google underwent an Initial Public Offering (IPO) in 2004. An investment of $10,000 in the IPO for in Google would have grown to $650,000 in September 2023.^[6]

Venture capital firms supported the messenger service WhatsApp’s growth. Sequoia injected approximately $8 million in 2011, with subsequent investments totaling over $60 million. Sequoia earned roughly $3 billion from WhatsApp. When Facebook (META) purchased WhatsApp for $16 billion, they reaped an additional windfall.

Uber is well known globally, but in 2010, it was just another startup. The company, then known as UberCab, raised approximately $1.6 million in funding from venture capital investors. Investors in the early round earned a 5,000x return at the 2019 IPO price of $45. Sequoia Capital partner Alfred Lin invested $30,000 in the seed round; this investment grew to $150 million at the IPO price.^[7]

Important Considerations

Venture capital investments can produce sizable returns for investors. In addition, venture capital is not highly correlated with the public stock and bond markets, which increase portfolio diversification, often leading to better risk-adjusted performance. However, these investments often come with significant risks, with a high probability that many companies will fail. When investing in venture capital, it is important to gain exposure to several companies to mitigate risk. VC funds provide an attractive way for investors to get diversified exposure to early-stage companies.

Venture capital is a funding source for early-stage startups and small businesses with high growth potential. It allows investors to support innovative ideas and businesses while reaping high rewards. Throughout this blog post, we have explored the role of venture capitalists, the differences between venture capital and private equity, the various stages of venture capital investment, and the success stories that have emerged from this dynamic industry.

If you are interested in exploring venture capital further and potentially benefiting from its high returns, we encourage you to contact BakerAvenue for a consultation. Our team of experts can provide valuable insights and guidance to help you navigate the venture capital landscape and make informed investment decisions. Don't miss out on the opportunity to be part of the next success story in venture capital.

Sources:

[1] https://www.wsj.com/articles/SB10000872396390443720204578004980476429190

[2] https://hbr.org/1998/11/how-venture-capital-works

[3] https://www.cambridgeassociates.com/insight/building-winning-portfolios-through-private-investments/

[4] https://www.accesswire.com/735688/Breaking-Down-Venture-Capitals-Out-Performance-of-Public-Markets-Perspective-from-Alumni-Ventures

[5] https://www.cambridgeassociates.com/wp-content/uploads/2019/11/WEB-2019-Q2-USVC-Benchmark-Book.pdf

[6] https://economictimes.indiatimes.com/markets/stocks/news/a-16k-investment-on-google-in-2004-ipo-would-be-worth-1-million-today-heres-how/initial-investment-of-10000/slideshow/103530105.cms

[7] https://www.wsj.com/articles/uber-like-other-unicorns-began-its-ipo-path-after-the-financial-crisis-11557417619?mod=article_inline