What is venture capital and how does it work?

Whether you’re booking accommodations through VRBO, grilling up a plant-based burger from Impossible Foods or purchasing groceries through Instacart, you use services and products from venture capital-backed companies every day.

Yet people not working in the industry are unlikely to know much about this dynamic, active and evolving world. Even though the global capital markets are always changing, the fundamentals of venture capital remain the same. In this article, we break down the basics of venture capital and explain what you need to know.

What is venture capital (VC)?

Venture capital (VC) is a form of financing where capital is invested into a company—a startup or small business—in exchange for equity in the company. To invest, VC firms employ general partners (GPs) to raise funds from investors called limited partners (LPs). Both the GP’s firm and the LP gain if the company does well. Companies use the capital invested into their businesses in many ways, including to build out their teams, expand their offerings, or reach a profitability milestone. VC is part of a larger, more complex part of the financial landscape known as the private markets.

Total VC raised and VC fund count (2012-present)

Venture capital 101: Understanding the fundamentals

What is a venture capital firm?

Venture capital firms are a type of investment firm that fund and mentor startups and other young companies. Similar to private equity (PE) firms, VC firms use capital raised from limited partners to invest in promising private companies. Unlike PE firms, VC firms often take a minority stake—50% ownership or less—when they invest in companies. A firm’s array of companies is called its portfolio, and the businesses themselves, portfolio companies.

Venture capital firms make money by collecting management and performance fees. These can vary from fund to fund, but the typical fee structure follows the 2-and-20 rule. Management fees are calculated as a percentage of assets under management (AUM), typically around 2%. These fees cover daily expenses and overhead and are incurred regularly. Performance fees are calculated as a percentage of the profits from investing, typically around 20%. These fees incentivize greater returns and are paid out to employees to reward their success.

Examples of venture capital firms include:

• Sequoia Capital: Headquartered in Menlo Park, CA, Sequoia Capital is a venture capital firm that invests in IT, mobile, internet, energy, media, retail sectors and more. The firm is an active investor in ghost kitchens, an emerging space tracked by PitchBook and it has invested in Uber, Bird, DoorDash, and 23andMe.
• Andreessen Horowitz: Also based in Menlo Park, Andreessen Horowitz is a venture capital firm that has invested in companies including Lime, Airbnb, Instacart, and Foursquare. As of October 2023, Andreessen Horowitz was gearing up to raise $3.4 billion for an early-stage fund and a seed fund, per Axios.
• DN Capital: London-based DN Capital is an early-stage VC firm that invests in software, fintech, mobile apps, digital media, e-commerce companies, and others. Founded in 2000, DN Capital founded well-known startups such as Shazam, Auto1, and Purplebricks.

What is a venture capital fund?

To raise the money needed to invest in companies, venture capital firms open a venture fund and ask for commitments from limited partners. This process allows them to form a pool of money, which is then invested into promising private companies. The investments they make are typically in exchange for minority equity—which is a 50% or less stake in the company.

For example, BioGeneration Ventures II is a top Dutch VC fund. Based in Naarden, Netherlands and led by founder and manager Edward van Wezel, it investments in healthcare companies across seed, early- and late-stages. The fully invested fund has committed capital to Cristal Therapeutics and Synaffix—both drug discovery startups—among other companies.

What is a venture capitalist?

Investors working at a venture capital firm are called venture capitalists. They actively seek out investment opportunities for the firm as well as help raise capital for venture funds. According to the PitchBook platform, there are more than 48,000 venture capital firms operating globally, and they all employ teams of venture capitalists. Using the example in the previous section, BioGeneration Ventures’ Edward Wezel, the firm’s founder and managing partner, is a venture capitalist.

What is corporate venture capital?

Within venture capital, there is a subset called corporate venture capital (CVC). A corporate venture capital firm makes investments on behalf of large companies that strategically invest in startups—often those operating within or adjacent to their core industry—to gain a competitive advantage or increase revenue. Unlike VC investments, CVC investments are made using corporate dollars, not through capital from limited partners.

Examples of corporate venture capital firms include:

• GV: As the corporate venture arm of Google’s parent company Alphabet, GV seeks to invest in technology and media sectors. Founded in 2009 and based in Mountain View, CA, the firm has invested in companies such as ClassPass, Lola.com, Brandless and theSkimm.
• General Electric Ventures: As the corporate venture arm of General Electric, GE Ventures invests in healthcare and life sciences, energy, mobility, and other sectors. Founded in 2013, the Boston-based firm has invested in companies including Carbon, Sarcos Robotics and Arterys.

What’s the difference between venture capital and private equity?

Both venture capital and private equity share the same goal: to increase the value of the business they invest in and then sell their equity stake (aka ownership) for a profit. However, they differ in four distinct ways:

• The types of companies they invest in
• The levels of capital they invest
• The amount of equity they obtain
• When they get involved in a company’s lifecycle

For a closer look at this topic, read our blog post about the distinctions between PE and VC.

The stages of venture capital fundraising

As companies grow, they go through the different stages of venture capital. Additionally, firms or investors may focus specifically on certain stages—which impacts how they invest.

Seed stage

When a venture capitalist provides a startup with a relatively small about of capital to be used for product development, market research or business plan development, it’s called a seed round. As its name suggests, a seed round is often the company’s first official round of institutional funding. Seed round investors are typically given convertible notes, equity or preferred stock options in exchange for their investment.

Early-stage

The early stage of venture capital funding is intended for companies in the development phase. This stage of financing is usually larger in sum than the seed stage because new businesses need more capital to start operations once they have a viable product or service. Venture capital is invested in rounds, or series, designated by letters: Series A, Series B, Series C and so on.

Late-stage

The late stage of venture capital funding is for more mature companies that may or may not be profitable yet but have proven growth and are generating revenue. Like the early stage, each round or series is designated by a letter. Series D, Series E and Series F are more common, but late-stage funding rounds can go up to a Series K.

If a company that a VC firm has invested in is successfully acquired or goes public, the firm makes a profit and distributes returns to the limited partners that invested in its fund. The firm could also profit by selling some of its shares to another investor in what’s called the secondary market.

Advantages and disadvantages of VC

External funding includes any capital raised or acquired from sources outside the company or its founder(s), inclusive of all venture capital funding rounds. Some pros and cons for founders who seek funding externally include:

Benefits of external funding

• The money founder(s) raise via VC fundraising is theirs to use however they see fit.
• VC capital can help a startup scale quickly.
• Founder(s) may benefit from access to venture capitalists and their extended networks.

Drawbacks of external funding

• Raising VC funds is a laborious process for founders, especially as they’re doing it while running day-to-day operations of their companies simultaneously.
• Investors own a stake in the startups they invest in, so they often want a say in decision making.
• Raising too much capital too fast is a main reason some startups fail, as scaling too quickly can lead to inefficient spending.

History of venture capital in the US

Some key historical dates related to US VC include:

• 1946: Post WWII, the first two US venture capital firms were founded.
• 1960s-1970s: VC firms focused on breakthroughs in electronics and medical technologies, leading to VC’s association with tech financing.
• 1971: The term “Silicon Valley” appeared in print for the first time, in the January 11 issue of the trade newspaper Electronic Times.
• 1978: After a temporary downturn, VC experienced its first major fundraising year.
• 1980: VC in Silicon Valley exploded after Apple Computer’s IPO, teeing the region up to become home to the world’s largest concentration of VC firms.
• 1990s: The invention of the World Wide Web reinvigorated VC.
• 2000-2003: When the Nasdaq crashed, the Internet bubble burst and the resulting slump sent shockwaves through the VC ecosystem.

Venture capital trends

PitchBook tracks trending venture capital news in real time via our News & Analysis VC coverage. On a quarterly basis, PitchBook analysts report on thematic trends and overarching takeaways related to the VC space in our Venture Monitor reports. As of the latest Venture Monitor report, which looks at Q3 2023, the venture capital trends at play right now include:

• Despite a few noteworthy IPOs in Q3, VC continues to stumble.
• Total exit value remains at an extreme low despite signs of an IPO-market thaw.
• GPs still deploying capital have slowed their activity dramatically, opting to keep dry powder close.
• Capital availability is in decline, moving the market further into investor-friendly territory.

Your resource for VC data, research, and insights

Millions of global entrepreneurs try their hand at launching new products and services each year, and venture capital—the money itself, the GPs who raise and distribute it, and the firms they work for—plays a large role in that.

After moving through pre-institutional and seed stage funding rounds, venture capital is often the next step toward securing the necessary funds to grow and sustain a business.

For data, research, and insights on all aspects of venture capital, check out PitchBook—an indispensable VC resource. Use PitchBook to find the right VC investors, raise venture funds, source promising VC investments, and so much more.