What Is a Venture Capitalist (VC)?
A venture capitalist (VC) is a private equity investor that provides capital to companies with high growth potential in exchange for an equity stake. This could be funding startup ventures or supporting small companies that wish to expand but do not have access to equities markets.
- A venture capitalist (VC) is an investor that provides young companies with capital in exchange for equity.
- New companies often turn to VCs for the funding to scale and commercialize their products.
- Due to the uncertainties of investing in unproven companies, venture capitalists tend to experience high rates of failure. However, for those investments that do pan out, the rewards are substantial.
- Some of the most well-known venture capitalists include Jim Breyer, an early investor in Facebook, and Peter Fenton, an investor in Twitter.
Who Are Venture Capitalists?
Understanding Venture Capitalists
Venture capitalist firms are usually formed as limited partnerships (LPs) where the partners invest in the VC fund. The fund normally has a committee that is tasked with making investment decisions. Once promising emerging growth companies have been identified, the pooled investor capital is deployed to fund these firms in exchange for a sizable stake of equity.
Contrary to common belief. VCs do not normally fund startups from the onset. Rather, they seek to target firms that are at the stage where they are looking to commercialize their idea. The VC fund will buy a stake in these firms, nurture their growth, and look to cash out with a substantial return on investment (ROI).
Venture capitalists typically look for companies with a strong management team, a large potential market, and a unique product or service with a strong competitive advantage. They also look for opportunities in industries that they are familiar with, and the chance to own a large percentage of the company so that they can influence its direction.
VC firms control a pool of money from other investors, unlike angel investors, who use their own money.
VCs are willing to risk investing in such companies because they can earn a massive return on their investments if these companies are a success. However, VCs experience high rates of failure due to the uncertainty that is involved with new and unproven companies.
Wealthy individuals, insurance companies, pension funds, foundations, and corporate pension funds may pool money together into a fund to be controlled by a VC firm. All partners have part ownership over the fund, but it is the VC firm that controls where the fund is invested, usually into businesses or ventures that most banks or capital markets would consider too risky for investment. The venture capital firm is the general partner, while the other companies are limited partners.
Payment is made to the venture capital fund managers in the form of management fees and carried interest. Depending on the firm, roughly 20% of the profits are paid to the company managing the private equity fund, while the rest goes to the limited partners who invested in the fund. General partners are usually also due to an additional 2% fee.
History of Venture Capital
The first venture capital firms in the U.S. started in the middle of the twentieth century. Georges Doriot, a Frenchman who moved to the U.S. to get a business degree, became an instructor at Harvard’s business school and worked at an investment bank. He went on to found what would later become the first publicly traded venture capital firm, American Research and Development Corporation (ARDC) in 1946.
ARDC was remarkable in that for the first time a startup could raise money from private sources other than from wealthy families. Previously, new companies looked to wealthy families such as the Rockefellers or Vanderbilts for the capital they needed to grow. ARDC soon had millions in its account from educational institutions and insurers. Firms such as Morgan Holland Ventures and Greylock Partners were founded by ARDC alums.
Startup financing began to resemble the modern-day venture capital industry after the Investment Act of 1958. The act made it so small business investment companies could be licensed by the Small Business Association that had been established five years earlier.
Venture capital, by its nature, invests in new businesses with high potential for growth but also an amount of risk substantial enough to scare off banks. So it is not too surprising that Fairchild Semiconductor (FCS), one of the first and most successful semiconductor companies, was the first venture capital-backed startup, setting a pattern for venture capital's close relationship with emerging technologies in the Bay Area of San Francisco.
Private equity firms in that region and time also set the standards of practice used today, setting up limited partnerships to hold investments where professionals would act as general partners, and those supplying the capital would serve as passive partners with more limited control. The number of independent venture capital firms increased in the following decade, prompting the founding of the National Venture Capital Association in 1973.
Venture capital has since grown into a hundred-billion dollar industry, with total investments of a record $330 billion in 2021. Today, well-known venture capitalists include Jim Breyer, an early Facebook (FB), now Meta, investor, Peter Fenton, an early investor in Twitter (TWTR), and Peter Thiel, the co-founder of PayPal (PYPL).
The value of all venture capital investments in 2021, a record-setting amount.
Positions Within a VC Firm
The general structure of the roles within a venture capital firm vary from firm to firm, but they can be broken down into roughly three positions:
- Associates usually come into VC firms with experience in either business consulting or finance, and sometimes a degree in business. They tend to more analytical work, analyzing business models, industry trends, and sectors, while also working with companies in a firm’s portfolio. Although they do not make key decisions, associates may introduce promising companies to the firm's upper management.
- A principal is a mid-level professional, usually serving on the board of portfolio companies and in charge of making sure they’re operating without any big hiccups. They are also in charge of identifying investment opportunities for the firm to invest in and negotiating terms for both acquisition and exit.
- Principals are on a “partner track,” depending on the returns they can generate from the deals they make. Partners are primarily focused on identifying areas or specific businesses to invest in, approving deals whether they be investments or exits, occasionally sitting on the board of portfolio companies, and generally representing the firm.
How Are Venture Capitalist Firms Structured?
VC firms typically control a pool of funds collected from wealthy individuals, insurance companies, pension funds, and other institutional investors. Although all of the partners have partial ownership of the fund, the VC firm decides how the fund will be invested, usually into businesses that are considered too risky for banks or capital markets. The venture capital firm is referred to as the general partner, and the other financiers are referred to as limited partners.
How Are Venture Capitalists Compensated?
Venture capitalists make money from the carried interest of their investments, as well as management fees. Most VC firms collect about 20% of the profits from the private equity fund, while the rest goes to their limited partners. General partners may also collect an additional 2% fee.
What Are the Prominent Roles in a VC Firm?
Each VC fund is different, but their roles can be broken down into roughly three positions: associate, principal, and partner. As the most junior role, associates are usually involved in analytical work, but they may also help introduce new prospects to the firm. Principals are higher-level, and more closely involved in the operations of the VC firm's portfolio companies. At the highest tier, partners are primarily focused on identifying specific businesses or market areas to invest in, and approving new investments or exits.