Innovation is a key economic driver and persistent differentiator in the United States. Many pioneering technologies, such as semiconductors, computers, the smartphone and artificial intelligence, would not exist without the risk-taking, entrepreneurship and venture capital that made them possible. Here’s an overview of venture capital, including how it works, the role it plays and how to raise it.
How does venture capital work?
Venture capital provides financing to startups working on novel technologies and innovations with a high potential to create value—but also with a high risk of failure. Venture capital usually takes the form of equity shares or a future claim on equity, such as convertible debt, which in return allows the venture capital firm to receive a share of ownership in the business.
Venture capital investors come in all shapes and sizes, but they generally have a long-term perspective. The time it takes for a company to grow and achieve success can be years, if not decades. From an investor perspective, success looks like an M&A or IPO transaction big enough to provide liquidity for all shareholders. However, the likelihood of any one investment resulting in a successful transaction where the return is much higher than the amount of investment, is very low. As a result, venture capitalists usually take a portfolio approach, spreading their investments across tens, if not hundreds, of companies.
The role of venture capital when building your startup
Venture capital’s main purpose is to help new, innovative startups grow. Before raising capital from a professional investor, a founder will tap their network of friends and family or participate in an incubator or accelerator to validate their idea and develop a minimum viable product. Some venture capital goes toward funding exploratory research and development and prototyping, but most is used to scale and commercialize a startup’s product or service. This includes investing in fixed assets for manufacturing, building out marketing and sales functions, or bolstering working capital.
The role of the venture capitalist or investor is to help the founders of a startup succeed. This can take many forms, but it usually boils down to advising on things like the state of the industry, achieving commercialization and benchmarking to peers. With a founder’s time often stretched, venture capitalists who advocate for and market a startup to their networks can be a big help. In addition, venture capitalists can leverage their networks to provide connections to the founder, such as other investors, potential customers and talent.