An introduction to venture capital

Venture capital is a form of private equity that involves investing money in early-stage companies that may have long-term growth potential.¹ Traditionally, venture capital has been reserved for accredited investors — or those with a net worth of more than $1 million or an income of over $200,000 (individually) or $300,000 (with spouse or partner) in each of the prior two years, with reasonable expectation of the same for the current year.² However, investing in venture capital has gradually become more accessible to investors as CAIS alongside others are broadening access to alternative investments for private wealth advisors. With that in mind, let’s examine the basics of venture capital. 

The Basics of Venture Capital 

The venture capital ecosystem consists of four distinct players:³ 

1. Entrepreneurs: Those who need funding for their company. 

2. Venture capitalists: Those who are looking to partner with companies and provide funding by pooling the capital of investors and creating a market to support the growth and transactions of early-stage businesses 

3. Private Investors: Those who are looking to invest in venture capital funds as a limited partner (LP). 

4. Investment Bankers: Those who are looking to bring these earlier stage companies to the market. 

For the purposes of this article, we will focus mainly on the role of venture capitalists (VCs). A VC's primary goal is to raise money from limited partners to invest in promising startups or even larger venture capital funds as an LP themselves. VCs will invest money across the market, and in companies that may be in different stages of growth. 

Companies may be in any of the following growth phases when seeking venture capital:⁴

1. Pre-seed stage: This is when a company is still in its infancy. Oftentimes, they are little more than an idea. Investors who invest at this stage are often considered “angel investors.” In exchange for capital, investors at this stage may be awarded convertible notes, equity or preferred stock options. 

2. Seed stage: This phase takes place when a company has built a viable product or service and has begun expansion. Since these companies cannot yet access sizable loans or the capital markets, venture capital is desired. These investments are also referred to in a series, starting with Series A funding, followed by future rounds like Series B and so on. Early-stage funding may support different needs of the organization such as hiring, marketing, or operations. 

3.  Late stage: This is when a company has proven its ability to generate revenue and venture capital is no longer required to scale. Late-stage companies have generally reached a point of positive cash flow generation, with the chance of profit, and thus begin to experiment with expanding into different markets 

4. Exit stage: Once a company has achieved a certain level of growth and future scalability, VC investors will seek to “exit” the investment and recoup their return on invested capital. At this point many additional players are brought into the deal, including private equity investors and investment bankers, both in search of high-growth deals to bring to market. These exits are typically achieved through an Initial Public Offering (IPO) or an acquisition from a larger company, which generates liquidity for the VC, with the chance to reap extraordinary returns.⁵ 

Venture Capital Investment 

Venture capital firms are vital for the success of younger companies and work alongside management teams to support the growth and development of these startups across numerous verticals. The investment process for venture capital firms involves a few critical steps which seek to ensure thorough evaluation of potential deals, strategic decision-making, and ongoing support for the selected companies. 

This process involves:⁶ 

1. Deal sourcing 

2. Conducting due diligence 

3. Development and presentation of term sheets 

4. Investment and documentation negotiations 

5. Provide support and guidance 

6. Advise on additional series funding and exit 

The venture capitalist will handle the active management of the fund, which includes sourcing new deals, helping new companies grow, and working alongside investment banks and private equity firms to exit profitable investments. In the early stages of a fund, LPs can contribute capital, with the potential to earn a return based on their contribution upon the funds maturity. 

Valuation in Venture Capital 

One of the trickiest parts of venture capital is assigning a value to a young company. With larger, established companies, investors can use metrics like cash flow and revenue to determine how much a company is worth. But, many young companies have very little revenue if any.   To assign value to young, growing company and determine the potential profitability of an investment, many venture capitalists will use the venture capital method.⁷ This method consists of six steps:   

1. Estimate the size of the investment that is needed 

2. Forecast the financials of the company 

3. Determine the approximate timing of an exit 

4. Calculate an expected multiple at exit 

5. Discount to present value at the desired rate of return 

6. Determine the valuation and desired ownership stake required 

These are the typical calculations that a principal investor in a VC fund will conduct. However, this calculation can be important for all LPs of the fund to know. 

Challenges and Opportunities in Venture Capital 

Venture capital firms work in a high-risk, high-reward asset class. This means many VCs invest in many companies, knowing that many of them will likely fail. For example, a VC might invest in 10 companies knowing that nine of them will fail. But, the one company that succeeds could generate a return that makes up for and offsets the loss of investing in the nine other companies. 

Let’s examine the pros and cons of investing in venture capital. 

Potential Benefits of Venture Capital Investing 

• High return potential: Investing in early-stage companies leaves a high potential for returns, with many funds aiming to return an expected 25% to 35% per year through the life of the investment.⁸ 

• Funding innovation:Venture capital investments often go to innovative and cutting-edge companies. By investing in this asset class, you can help contribute to technological advancements and economic growth. 

• Diversification: As an alternative asset, investing in VC funds can allow for diversification away from more traditional asset classes like public equity and fixed income.

Risks of Venture Capital Investing 

• High Risk of Failure: Many early-stage companies fail completely. If this happens, it means that investors will likely lose the entirety of their investment. 

• Lack of Liquidity:Venture capital investments are typically illiquid, meaning they are difficult to redeem at short notice, if at all. In some cases, investments may be tied up for several years.  

• Long Investment Horizon:Venture capital investments often have a long time horizon, with returns potentially taking many years to materialize. This can be a drawback for investors looking for more immediate returns. 

• Limited Control: Investors in VC funds often have limited control over the operations and decision-making of the startups in which they invest. This lack of control can be challenging for those who prefer a more hands-on approach 

• Higher Fees: Some VC funds charge higher management or performance-based fees that can lower overall returns for investors.