New business ventures are exciting, but there’s a big hurdle on the path to making it big for many: Growth is expensive.
Young companies often need outside capital to grow. Lenders, investment banks, and capital markets often turn early-stage companies down, citing high investment risk.
That’s where venture capitalists come in. These investors are willing to take a chance on the next big idea — investing millions of dollars in promising startups in the hopes that some of their bets will pay off.
What Is a Venture Capitalist (VC)?
A venture capitalist is a private investor who invests in early-stage small businesses in exchange for an equity stake. However, unlike angel investors, venture capitalists don’t act alone.
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They’re part of venture capital (VC) firms.
VC firms seek high-growth investment opportunities in companies that have a unique product and a large target market. These companies are usually just hitting the commercialization stage of the business cycle, meaning their products are just making it to market. They’re considered too high-risk for most lenders, investment banks, and capital markets.
Venture capitalists generally seek to purchase large stakes in the companies they fund — typically 20% to more than 50%. They like to manage the risk of doing so by inserting themselves into the companies’ boards of directors and supervising their executives.
How Venture Capital Works
VC firms are generally structured as limited partnerships. The venture capital firm becomes the general partner, which is the partner that makes the ultimate decisions, while investors become limited partners.
These firms are usually formed by groups of accredited institutional investors often including wealthy individuals, foundations, pension funds, and insurance companies.
Once the fund is formed and funded by the partners, it looks for opportunities to invest in new companies with high growth potential. In particular, the fund looks for companies that:
- Have a Unique Product. The product must be unique enough to solve a problem in a way that no other products do.
- Have Some Sales. Venture capitalists want to get in early. However, in most cases, they’re not interested in investing in companies that don’t have any revenue. Their goal is usually to find a product that’s just starting on the commercialization path and has promising early sales results.
- Have a Large Target Audience. These investors aren’t interested in companies that have the potential to grow to generate $2 million or $3 million in annual sales. They invest in companies that address the masses and have the potential to earn hundreds of millions of dollars per year if everything goes right.
- Have an Effective Management Team. Venture capitalists usually assist management because they invest enough to own a meaningful percentage of the companies they invest in. However, they want to make sure the management team is already on the right track before investing.
- Have Intellectual Property. Most VC funds look for companies that already have patents, trademarks, and other intellectual property in place. These are key aspects of what Warren Buffett calls the economic moat.
Once it spots an investment target, the VC firm negotiates an investment amount and equity stake with the target company. If all goes well, the firm makes the investment and owns a meaningful piece of the growing company.
Moving forward, members of the investment firm take an active role in the companies it invests in, often joining their boards of directors. Their goal is to grow the company as quickly as possible to produce one of three outcomes:
- Initial Public Offering (IPO). The firm’s goal may be to grow the company to the point where it’s appealing to public capital markets. At this point, it’s ready to list its shares in an IPO at a valuation far higher than it paid when it invested.
- Acquisition. In some cases, the venture capital fund builds the company it invests in with eyes on a buyout in the end. This is often the case in industries that are dominated by a small group of goliath-sized companies who are willing to make large investments in new technologies to maintain their leadership roles.
- VC Acquisition. The VC firm might decide its best option is to acquire 100% of the company over time and generate profits through corporate operations.
Most investors in a venture capital fund are passive investors. However, the firm itself is run by the active parties who charge management fees for their services.
A typical management fee is about 20% of the profits generated by its investments. But not all VC firms are profitable due to the considerable risks of investing in young companies. Most VC bets never produce the hoped-for returns.
Venture Capitalist Qualifications
Venture capitalists come in all shapes and sizes. There are no set criteria for becoming one, but your best bet is to have the following qualifications:
- Sufficient Education. Most venture capitalists have at least a bachelor’s degree. If you’d like to become one, seek a degree in a field related to business or finance.
- Work Experience. VCs tend to take an active role in the companies they back. It’s best to have extensive work experience in the industry in which you plan to invest.
- A Strong Network. You’ve heard the saying, “It’s not what you know, it’s who you know.” In the venture capital space, success boils down to a little bit of both. Never give up the opportunity to make a meaningful connection with a leader in your industry of interest.
- A Mentor. A mentor isn’t a requirement, but it’s best to have one. As a business enthusiast, you likely have high-power friends on social media or connections to leaders through your work experience. Reach out to these leaders and build relationships. When the time is right, ask them to become your mentor. You’d be surprised how many people are willing to help others succeed regardless of their own level of success.
Venture Capitalists vs. Angel Investors
Venture capitalists and angel investors are often mentioned in the same sentence. That’s for good reason.
Both venture capitalists and angel investors are deep-pocketed investors with an affinity for business and a willingness to reward entrepreneurship by taking a chance on the underdog. Both also invest in exchange for an ownership stake in private companies and seek early investments to maximize their growth potential.
But they’re also very different.
As mentioned above, venture capitalists act as a group of investors. The investors are usually a mix of high-net-worth individuals, pension funds, foundations, and insurance companies.
Angel investors are more likely than venture capitalists to act alone. However, in some cases, they join groups to make themselves more visible and increase overall buying power.
Regardless of their preferred modus operandi, angels are high-net-worth individuals with no fiduciary responsibilities to investors. This is an important difference because acting alone or in small groups has a meaningful impact on capital abilities and the decision-making process.
Both venture capitalists and angel investors invest in startup companies. However, the style of startup companies these investors target are very different:
- Venture Capitalist. Venture capitalists target companies that are already making their way through their business plans. These companies have a product that’s already being well received by a small audience and generating at least minimal revenue, intellectual property, and a clear growth path.
- Angel Investors. Angel investors tend to invest earlier in a business’s lifecycle. In many cases, the angels invest before the entrepreneur develops the final product or even has intellectual property.
The amounts the investors are willing and able to put on the table is one of the biggest differences between venture capital and angel investing:
- Venture Capitalists. Venture capitalists are funded by groups of big-money investors and usually invest millions of dollars into the companies they support. Individual venture capital investments span a broad range from a few million dollars to tens of millions of dollars.
- Angel Investors. Angel investors act alone and have a smaller amount of money to work with. In most cases, angels invest anywhere between $25,000 and $100,000 in the startups they support.
Due Diligence Responsibilities
Due diligence refers to the research investors do prior to making an investment. VC firms and angel investors have very different responsibilities in terms of this research.
- Venture Capitalists. VC firms represent a group of investors. This is a fiduciary role that comes with a responsibility to act in the best interests of the investors of the fund. Accordingly, VC firms do extensive research into their target companies before making investments.
- Angel Investors. Angel investors invest with their own money. They have no fiduciary responsibility to anyone and aren’t necessarily required to do any research. Angel investors are often criticized by investing experts who value detailed fundamental analysis for making poor investment decisions due to a lack of due diligence.
How to Become a Venture Capitalist
One of the easiest ways to become a venture capitalist is to have a ton of money and experience in an industry where innovation is common. However, most people don’t fit that bill. Another option is to earn a bachelor’s degree in finance or business and work for a VC firm.
Although each firm may have its own names for the roles they employ, workers at the firm usually fall into one of the three following categories:
- Associate. Associates take an analytical role in VC companies. They’re tasked with analyzing business models, sectors, market sizes, and industry trends and working with companies in the firm’s portfolio to capitalize on the data.
- Principal. Principals at VC companies are in leadership positions and often serve on the boards of the companies they invest in. Their job is to ensure that everything runs smoothly from a big-picture perspective and that the investment process remains free of major mistakes. They may also take the lead on negotiating new deals.
- Partners. When principal members of VC companies make profitable deals and show leadership in curating the companies they invest in, they’re often promoted to partners. As partners, their role continues to include their work as principals as well as working to nurture other principal members of the company. As partners, these members of the fund have an ownership stake in the venture fund itself. They also continue to make meaningful decisions and sit on the boards of companies they represent.
Venture Capitalist FAQs
Venture capitalists are an interesting breed. They’re usually highly successful professionals with a keen ability to dig up high-growth investment opportunities in the private sector.
If you have questions about this unusual profession, you’re not alone. These are some of the most common.
Why Are Venture Capitalists Important?
Venture capitalists are critical players in both the economy and innovation. These investors provide funding to budding companies that most in the investing community deem uninvestable.
Without venture funding, many of these companies would die on the vine as growth costs outpace revenue. So VC firms help breathe new life into early-stage firms growing in capital-intensive markets.
When these companies make it through the growing pains, they often become massive corporations that provide jobs and contribute to economic growth.
What’s the Difference Between Venture Capital vs. Private Equity?
Venture capital is a form of private equity, but all private equity isn’t venture capital. Private equity funds are groups of private investors that invest in companies or buy them outright and restructure them. Private equity firms buy companies of any size and often take public companies private.
What Are the Benefits of Becoming a Venture Capitalist?
Venture capitalists enjoy rewarding careers for several reasons. Successful venture capitalists don’t simply make huge amounts of money — they often do so while helping others.
Some of the biggest benefits of becoming a venture capitalist include:
- The Money. Venture capitalists take big risks with huge amounts of money, but when investments go well, the returns can outpace the overall market by multiples.
- Helping Others. Venture investments are the breath of air that gives struggling companies new life. These investors sleep well at night knowing they’re helping make dreams come true for the entrepreneurs they support.
- Never a Dull Moment. Venture capitalists are constantly seeking the next great investment opportunity while working to improve operations at the companies they invest in. You’ll never be bored in this line of work.
What Are the Risks of Becoming a Venture Capitalist?
Becoming a venture capitalist can be rewarding, but it can also be very risky. Some of the biggest risks involved in the job include:
- Liquidity. VCs invest in companies that other investors deem to be uninvestable. They’ll have a hard time finding a buyer if they decide to make an early exit.
- Time Commitment. Venture capitalists don’t just invest a lot of money, they invest a lot of time. These professionals are constantly looking for and negotiating new deals while analyzing and helping manage the companies they already invest in. VCs often work well over 40 hours a week.
- Potential Losses. There’s usually a reason investors and banks deem companies to be uninvestable. As a VC, you invest in these high-risk companies in hopes of big returns. However, some investments will go wrong, and when they do, they’ll result in significant losses.
The venture capital industry is one of the most important industries in the United States. Many of the companies that make the products you know and love wouldn’t be around today if it weren’t for the early venture capital investments they received. Facebook, Apple, and Tesla are a few good examples of companies that raised venture capital as startups and grew to be market leaders.
Successful VCs also happen to be very wealthy individuals. They earn their wealth with an impressive ability to research and analyze early-stage investment opportunities, then take the reins of struggling companies to steer them toward growth.