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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What Is Venture Capital?
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.
Read more with eSecurity Planet’s Top 20 VC Firms in Cybersecurity.
How Does Venture Capital Work?
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.
Also read: Data Startups: Why the Eye-Popping Funding Rounds? | IT Business Edge
What Is a Term Sheet?
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:
- Drag-along: Prevents minority shareholders from blocking sales of the company.
- Tag-along: Offers minority shareholders the right to join sale by majority shareholders.
- No-shop: Prohibits companies from seeking external investment proposals.
- Pro-rata: Investor’s right to participate proportionally in future funding rounds.
- Right of first refusal: Investor’s right to buy shareholder’s stock before third-party inquiry.
- Co-sale: Investor’s right to join in another shareholder’s stock sale.
- Vesting: Commits founders to work with shares as the investor pool grows.
Caption: A term sheet template offered by Y Combinator to entrepreneurs and startups.
Read more: Top Cybersecurity Startups to Watch | eSecurity Planet
Venture Capital vs Equity and Debt Financing
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: Funding in exchange for an ownership stake in the company.
- Debt financing: A loan where the company repays the principal with interest.
Private Equity vs Venture Capital
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.
Debt Financing vs Venture Capital
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.
Also read: 5 Top VCs for Data Startups | IT Business Edge
Top VC Firms
- Bessemer Venture Partners
- ForgePoint Capital
- GV (Google Ventures)
- Insight Partners
- Intel Capital
- Kleiner Perkins
- Lightspeed Venture Partners
- New Enterprise Associates (NEA)
- Sequoia Capital
- Tiger Global
Read more: AI investments soared in 2021, but big problems remain | TechRepublic
History of Venture Capital
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.
Read more: Some Cybersecurity Startups Still Attract Funding Despite Headwinds | eSecurity Planet
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.