Venture capital (VC) offers startups and developing businesses growth opportunities with funding from private investors for an agreed-upon stake in the company.
While private equity (PE) refers to any investment in non-public companies, venture capital is a type of PE focused on long-term investments, small businesses, and early funding opportunities. For 50 years, the proliferation of VC investing has fueled the growth of new industries, including much of the information technology (IT) ecosystem.
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Venture capital is a private investment focused on businesses before their initial public offering (IPO), acquisition, or maturation as a private company. VC firms create funds that target market sectors ideal for development and allocate funding to cover scaling expenses. In exchange, companies agree to the investor’s terms, giving investors an ownership stake in the company through equity.
Unlike publicly traded stocks, VC funds are illiquid investments and often part of a 10-year or longer funding horizon. Because VCs primarily focus on underdeveloped companies, the failure rates can be high. In turn, the risk-return ratio is high, incentivizing VC firms to diversify their investments within or across multiple sectors.
Venture capital is the system within financial markets where VC firms, made up of General Partners (GP) and Limited Partners (LP), establish funds for specific sectors and early funding opportunities.
GPs manage the VC fund and work to raise capital from LPs while pursuing investment opportunities for allocating funds. While LPs provide capital to the fund, GPs direct the flow of investments to prospective companies to support the financial objectives of the fund.
GPs look for startups and developing companies with a strategic market position, unique value proposition, and strength in company management. When they agree to a VC term sheet, companies sometimes must also agree to aggressive timetables for growth and company direction.
Term sheets outline an agreement between a VC firm and a business to fund the company under certain conditions. Term sheets typically land in a founder’s inbox after the VC firm conducts due diligence and wants to proceed with funding.
Term sheets offer a transparent view of the equity and investment terms of the relationship at all stages. Primary term sheet data includes the investment size against the valuation, conversion rights, liquidation preference in the event of bankruptcy, and potential dividends.
Other common term sheet clauses include:
Caption: A term sheet template offered by Y Combinator to entrepreneurs and startups.
When starting a company, entrepreneurs must raise capital to acquire equipment, hire personnel, and test their business model. Today, founder funding options primary split into:
Private equity firms manage the entire lifecycle of private assets and specialize in alternative investments to the public stock market, including venture capital, leveraged buyouts (LBO), and mezzanine financing.
VC is a popular type of private equity that often refers to early-stage and pre-IPO funding, while PE often refers to other private investments and comprehensive firms. Notable private equity firms like KKR, Thoma Bravo, Bain, and Blackstone target existing public companies for purchase, leveraged buyouts, or equity funding.
Before the emergence of private equity, debt financing was – and still remains – critical to economic development. Through a bank or central financial institution, debt financing offers individuals and businesses loans to fund business ventures without sacrificing ownership in the underlying company. Banks can lend necessary funds with the expectation of repayment with interest, and startup founders can retain full ownership as long as payments are met.
In 1946, Harvard professor and World War II veteran, Georges Doriot, founded the American Research and Development Corporation (ARD) to invest in U.S. veterans’ businesses upon their return home. While significant private investments were previously limited to the wealthiest institutions and families, ARD and J.H. Whitney & Company stand out as early firms that offered companies an alternative to bank debt financing.
A decade later, the Small Business Acts of 1953 and 1958 established the tax and financial incentives to encourage private equity investments in developing businesses. Subsequent changes to employee retirement funds also opened the doors to pension funds working with VCs.
Fast forward to 1972 in Menlo Park, California, the birth of firms like Kleiner Perkins and Sequoia Capital was the start of a gold rush of private equity in technology. Some of the first investments contributed to the development of the semiconductor industry, dubbing the surrounding region “Silicon Valley.”
In the next two decades, the VC industry matured with extensive firm entries, increased assets under management, and adjustments to stock market fluctuations. The 1990s and the emergence of today’s biggest IT companies again led to a boom in VC activity before its most considerable adjustment to date, in response to the 2000 bursting of the Dot-com bubble.
Twenty years later, the VC industry has experienced a meteoric rise up to 2022. According to PitchBook, the VC industry almost doubled its capital invested, increasing from $166.6 billion in 2020 to $329.9 billion in 2021. Before 2021, the industry experienced steady growth in the number of deals (deal count) and value of deals, as shown below.