Venture capital in plain English
Venture capital (VC) is a type of private investment in startups that are young, risky and have the potential to grow very large. Instead of lending money, VC investors buy a stake in the company. If the startup becomes worth billions, that stake can return many times the original investment. If it fails, the money is usually lost.
VC has funded many of the world's biggest technology companies before they went public. It is a specialized corner of finance: a small number of firms, a small number of startups each year, and outcomes that are mostly either very large or zero.
Where the money comes from
A VC firm usually does not invest only its own money. It raises a fund from outside investors:
- Limited partners (LPs): the investors who supply most of the money, such as pension funds, university endowments, foundations, insurance companies, sovereign wealth funds, family offices and wealthy individuals.
- General partners (GPs): the VC firm's partners who choose and manage the investments. They usually commit some of their own money too.
LPs back VC funds because a small slice of their portfolio in high-risk, high-reward assets can lift overall returns, and because it gives them exposure to fast-growing private companies they could not buy on the stock market.
How a VC fund works
- Fundraise: the firm raises, say, a $200 million fund from LPs.
- Invest (roughly years 1 to 4): partners invest in a portfolio of perhaps 20 to 40 startups, keeping a large reserve for follow-on investments in the winners.
- Support and grow (years 3 to 8): partners help with hiring, strategy and later fundraising, often from a board seat.
- Exit (years 5 to 10+): companies are sold to bigger firms or go public, and the fund returns cash to LPs.
A typical fund has a life of about 10 years, often with extensions. Firms raise a new fund every few years, so a successful firm has several funds running at once.
How VCs get paid: "2 and 20"
- Management fee: often around 2% of the fund per year, which pays salaries, offices and running costs.
- Carried interest ("carry"): often around 20% of the fund's profits, paid only after LPs have got their money back. This is where partners make most of their money.
The exact terms vary; top-performing firms can charge more, and newer or smaller funds may charge less.
The power law: why VCs swing for huge outcomes
Most startups fail or return little. A typical VC portfolio might look like this:
- Many companies return nothing or less than was invested.
- Some return their money a few times over.
- One or two become enormous and return more than the whole fund.
This is called a power-law distribution. It shapes how VCs think: a company that can "only" become a solid $50 million business may not be worth their time, because it cannot pay for all the failures. That is why VCs look for huge markets and push for rapid growth, and why a VC rejection is not necessarily a judgment that a business is bad.
What VCs look for
- Team: founders with deep knowledge of the problem, the ability to recruit and the drive to keep going.
- Market size: a market big enough to support a company worth billions.
- Product and traction: evidence customers want it, such as growing revenue, usage or retention.
- Edge: technology, data, network effects or distribution that competitors will find hard to copy.
- Timing: why now? A new technology, regulation or behavior shift that opens the door.
Stages of venture investing
Firms often specialize by stage. Pre-seed and seed funds write small checks into very early companies; early-stage VCs lead Series A and B rounds; growth funds invest larger amounts in later rounds. Our guide to how startup funding works walks through each round, valuation and dilution.
VC vs. angels vs. private equity
| Angel investors | Venture capital | Private equity | |
|---|---|---|---|
| Whose money | Their own | LPs' money in a fund | LPs' money in a fund |
| Company stage | Very early | Early to late-stage startups | Mature, usually profitable companies |
| Stake | Small minority | Minority stake | Often majority or full control |
| Uses debt? | No | Rarely | Often (leveraged buyouts) |
Pros and cons for founders
Pros: large amounts of money without loan repayments, experienced advisers, introductions to customers and hires, and credibility for later rounds.
Cons: founders give up ownership and some control, investors expect very fast growth and an exit within a fund's lifetime, and terms such as liquidation preferences can leave founders with less than headline numbers suggest. Many good businesses are better off bootstrapped or funded by revenue, loans or grants.
How VC trends show up in the news
Headlines about "VC funding falling 30%" or "a new $1 billion fund" are signs of how much money is flowing to startups. Funding tends to boom when interest rates are low and stock markets are strong, and to tighten when rates rise or IPO markets close. Hot sectors attract a flood of money and rising valuations, which is how a wave of unicorns appears.
