Understanding venture capital

Venture capitalists are generally  in the business of turning “what if?” into “what is.” They invest alongside entrepreneurs and provide the money, support, and other resources needed to fuel innovation and turn a vision into a business.

Venture capital (VC) is one of several asset classes within private markets that allows you to tap into the growth and value found in the large and diverse universe of private companies. 

Joe Lonsdale, Opto Co-founder, introduces venture capital

Why you should be excited about venture capital

Venture is a very exciting but relatively risky asset class in which to invest. There is more uncertainty, but if a fund hits on a future unicorn, the upside can be great.

What does this mean from an investment perspective? 

Median returns from VC funds have exceeded those from their actively-managed public counterparts over the last two decades¹, and high-performing funds have done very well (see chart below). But at the same time, poorly-performing funds have done badly. Even among private markets funds, the range of outcomes is wide for VC.

Venture capital has been a leading driver of growth in the tech industry since the turn of the millennium. Early tech accelerators, such as Y Combinator and Techstars, provided a wealth of potential investment opportunities for VC, which was in its own early-growth stage. 

VC continues to fuel innovation, offering early-stage exposure to artificial intelligence and machine learning, software-as-a-service (SaaS), biotechnology, logistics, and other areas harder to access through public markets. These funds have now backed 70% of the tech companies that have gone public in the first 20 years of the century, pouring $2.9T into these innovative, entrepreneurial firms (see chart below).

While VC and the universe of private companies were growing, the universe of public companies was shrinking, triggered by tighter accounting and regulatory disclosure requirements for public companies, implemented in the early 2000s. In the year 2000, there were 24.51 listed companies per 1M people in the US: By 2019, that number had dropped to just 12.99.²

In contrast, the number of private companies keeps growing. A record-breaking 5.4M new companies launched in 2021, and 5.1M were formed in 2022, providing ample opportunity for VC investment.³

Put simply, if you are not investing in VC, it is very difficult to gain exposure to these companies at the earliest stages of innovation and with the greatest potential for growth.

What is venture capital?

Venture capital (VC) provides funding for early-stage companies that typically have high revenue growth potential. Venture capitalists invest alongside entrepreneurs with the ultimate goal of creating substantial value and a profitable exit. They usually take a minority stake, and may participate in a follow-on investment as the company grows.

Exits, which might be an initial public offering (IPO), or a sale, generate returns for investors. 

Because these companies are so early in their development, they generally require multiple rounds of funding (see chart below). Not all venture-backed companies will progress through all these stages. Some will remain private, while others will run the full range to IPO. Many more will fail along the way. This is the nature of investing in early-stage concepts and companies and not a “failure” of VC investing.

Opto co-founder Joe Lonsdale discusses the concept of financing rounds in VC

While they do not assume full control of portfolio companies, venture capitalists typically invest their time and leverage their networks of relevant connections to support the founders any way they can. Usually, they take a board seat and play an active role in the company’s strategic planning and growth. Depending on their expertise, they may target specific markets, such as healthcare or technology, or they may invest in different growth stages.

In the beginning…

Early-stage VC is a true “what if” investment. It is generally split into seed and start-up stages.

Seed-stage funding happens before a company is officially set up. This money is typically used to develop a new product or service. If successful, the entrepreneur then receives start-up funding to set up a company and bring the product or service to market.

Growing up…

Once a company has a proven business model, along with consistent revenue, and profitability, it is ready for the next stage. Mid-stage VCs build on the foundational work done by the early-stage investors. They generally use their cash and leverage their connections to scale the business and improve operational efficiency.

Late-stage VCs focus on optimizing their portfolio companies, looking to sharpen their competitive edge, and potentially help them get ready for an exit.

Growth equity funds

Some companies may choose to access growth equity funding and remain private longer, or even indefinitely.

Growth equity funds are a bridge between venture capital (VC) and private equity buyout funds. Similar to VC funds, they do not seek full control of a company, making minority investments, but in more established companies with relatively proven business models that retain growth potential. They provide money and support to expand operations and accelerate growth. The expansion of funds in the growth equity space has been an important factor in companies remaining private for longer, with investment firepower that allows companies to pursue growth more strategically in the absence of daily public market pressure. 

How do I invest in venture capital?

It takes time, money, deep expertise, and patience to grow a company from concept to success. For every company that succeeds, there are multiple failures. Unicorns (startups with a $1B valuation) are rare for a reason. Finding the success stories in the millions of companies that launch every year in the US is a mixture of art, science, experience, and expertise.

In 2022, there were over 5M business applications filed with the US Small Business Administration (SBA). SBA data further shows that in 10 years (the rough lifespan of a VC fund), fewer than 30% of those companies may still be in business.⁴

Given the improbability of making successful individual choices, it is far too risky for most people to invest directly. Most people therefore choose to invest through VC funds, or a fund of funds, to access this exciting universe of growing companies. 

Venture capitalists know how to look for innovative ideas that solve real problems and, crucially, are monetizable, and the capable founders with the grit and skill to make the business a success. Their teams evaluate business plans, assess markets, and competitive landscapes, and ultimately look to identify the best investment opportunities.

These funds are set up as limited partnerships and the money is contributed by individual or institutional investors, who are limited partners (LPs - see “Acronym watch” below).⁵ The general partner (GP) is responsible for making and managing investments with the money contributed by the LPs, who are generally passive.

Lifecycle of a VC fund

It takes time and patience to grow companies and earn returns. Like wine, a fund begins with its vintage year and then ages until it is harvested. This usually takes 10 years or more. A fund may vary in size from a few million to more than a billion dollars, depending on the strategy. VC funds move through distinct stages over their lifecycle: 

• Formation and capital-raising. The fund manager (or GP) defines the fund, including strategy and fund size. Legal documents are put together and contain the fund’s terms, governance, and fees. The GP then takes the fund to market, securing capital commitments from qualified investors, including high-net-worth individuals, endowments, and pension funds, among others.

• Investment period. This phase starts with sourcing, evaluating, and selecting high-potential companies that meet the fund’s strategic goals. The next step is extensive due diligence on those companies. Because of the early-stage nature of venture investments, due diligence focuses heavily on sector and product, and less on financial analysis.

If all of the GP’s investment criteria are met, it looks to strike a deal. Depending on its size and targeted level of diversification, a fund typically builds a portfolio of anywhere from 10 to 25, or even more, portfolio companies.

• Active support period. The fund manager works with portfolio companies to devise and implement strategies to drive growth and add value (as per our discussion above). They closely monitor and report back to investors/LPs on the portfolio companies’ progress.

• Exit or harvest period. When the GP is satisfied with the company’s financials, governance and market position, and - more importantly - deems that the market environment for a sale is appropriate, they create an exit. As discussed, common exits are IPOs, mergers, or private sales. Investors are paid from the proceeds of profitable exits, with the GP receiving an agreed-upon cut.

• Liquidation. When the fund’s last investment is complete, the LPs and the GP are paid and the fund is closed.

A VC fund might look to make follow-on investments in high-achieving startups to support its expansion and development and benefit from its expected continued success.

Returns from a VC fund

The structure of a VC fund’s lifecycle means that the way cash is returned to investors is fundamentally different from that of public mutual funds.

Most simply, as mentioned above, there are no daily reported returns. Instead, investors receive quarterly estimates of the value of the overall portfolio, with that only turning into cash during the “harvest period” of the fund, which may not begin until five or more years into the fund lifecycle.

At the beginning of the investment phase, VC funds often produce negative returns, which forms the downward slope in what is called the “J-curve.” This downward movement is because during the early stages of a fund, the fund is making investments. It may have to pay a premium to a company’s current value, resulting in an immediate (if short-term) loss. It may also face significant deal-related costs, such as legal fees and planned cash injections to implement its growth strategies. This decreases the fund’s overall value.

As the fund moves past its early stages, those returns typically gradually turn positive. In the later stages the upward slope of the “J” hopefully continues to steepen as expenses decrease and successful exits accrue.

VC investments are therefore long term. During that time, your investment is largely illiquid. You cannot sell your investment in a VC fund like you can a mutual fund. 

That said, VCs do not demand your money up front. Committed capital is the cash you agree to invest in a fund throughout its life. Called capital is the money the fund manager collects from you as it makes investments. You get capital calls throughout the investment period with little notice, so you will need to be able to mobilize cash fairly quickly to meet these calls.

Fees in a VC fund

VC fund fees are structured differently from the flat fees you pay for a mutual fund. Designed to incentivize the GP to do their best, there are two types of fees, as well as some general expenses. We talk about this in more depth here, but in short…

Management fees

First, there is an annual management fee that covers most of the fund’s basic operating expenses. This typically includes salaries, office rent, legal and due diligence costs, and other administrative costs. This fee usually ranges from 1% to 2.5% of the capital you committed.

Performance fees

The fund manager also receives a share of the fund’s profits, commonly called carried interest or just “carry.” The standard carry is around 20%, but it may vary depending on the terms of the fund agreement. 

Aligning interests

As this performance fee structure makes evident, there is strong alignment of interests in VC between investors and the fund managers.

Put simply, if a fund is successful, the manager profits. If not, they take the losses alongside their investors. Of course, we should note that management fees provide a small amount of income for the manager throughout the fund life.

Risks of a VC fund…

As in any other investment, you can lose your money. As mentioned above, there is a much wider range of outcomes in private markets than in public markets, and VC has among the widest distribution in private markets. If you end up at the wrong end of that range, it means losses for investors and managers alike.

Seed- and early-stage companies are inherently risky, as they generally have yet to find a product-market fit and are frequently operating at a loss at the time of investment. Portfolio companies may underperform or fail for many reasons. The market for the company’s product may shift or disappear. The founders may not be able to execute the plan, or an exit may not be possible. The competition within a given sector may beat the portfolio company.

There are also market and economic risks for VC investments. An interest rate change, persistent inflation, or a recession can hurt a portfolio company’s performance and a fund’s opportunities to engineer a successful exit. Similarly, a change in the regulatory environment could also present a risk to the fund or to a portfolio company.

Finally, traditional VC funds are unavoidably long term and illiquid, which carries an opportunity cost for investors, while the lack of daily reporting is something investors would have to get comfortable with.

Nevertheless, we would argue that with careful fund selection, appropriate levels of diversification, and the support of the right partners, VC has a highly constructive role to play in a well-balanced portfolio.

…and the potential rewards

Google, Amazon, Tesla, and Uber, were all venture-backed visions. Past performance does not guarantee future results, but venture capital offers the compelling opportunity to invest ahead of the curve and in something you truly believe in.

We recently identified sectors of VC-backed innovation that we are excited about, including:

• Software-as-a-service

• Biotech

• Energy, including clean fuels and renewables

• Defense procurement

• Logistics

As well as, of course, artificial intelligence (AI), which is one of the hyped areas of VC-backed innovation. AI is starting to redefine work, medicine, transportation, and more. Investing via private markets at this early stage may offer greater upside, and the opportunity set is only likely to grow as AI evolves and becomes ubiquitous.

Still curious? Click on the venture capital tab on our Insights site.