Venture Capital Fundamentals: Why VC Is A Driving Force Of Innovation
Sometimes, it takes a monumental event in an unfamiliar sector to open our eyes to how complex and important things are, and how much the general public doesn’t understand. The recent banking crisis has been such an event. Despite the fact that private market investing and venture capital (VC) are critical factors in our nation’s position as a global innovation leader, it’s relatively unfamiliar to many people.
In an effort to create some clarity and understanding, this VC primer explains how VC works and why it’s so important to founders seeking capital and to investors seeking to diversify their portfolios.
The Fundamentals of Venture Capital
Put most simply, VC is a category of private market investment and financing. A VC firm raises capital (i.e., money) from investors, often referred to as Limited Partners (LPs). The firm uses that capital to fund promising startups they have determined as likely to have high growth potential in an emerging category.
Venture capitalists sit at the intersection between founders and investors. Relationally, they balance their intent between providing investors with an attractive return on capital and providing entrepreneurs with the support they require to scale their businesses toward success. Financially, VCs are a conduit between invested capital from an LP and capital invested in a promising founder and their company.
At a macro level, this category of investment and funding keeps the economy from stagnating. VC is an important engine of economic growth and progress, both in the U.S. and around the globe. Since the earliest recorded history, innovation has driven economic momentum (consider the wheel, radio, or agricultural tools). Funding for those ideas and inventions is necessary to bring them to market. That’s why for entrepreneurs and private market investors, VC can be one of, if not the, most meaningful capital and wealth-building resources available.
How VC Works for Entrepreneurs
For entrepreneurs, VC capital and support represent a lifeline during the later phases of the ideation-invention-innovation life cycle when they are taking a product or service to market. Often, it is the first institutional capital that a startup takes once it has gained initial traction from its customer base.
It is an option that exists between independent funding sources like friends, family, or corporate contributors and ‘traditional’ low-cost capital resources like SBA loans. Approximately 80% of the time, VC funding serves to secure and scale infrastructure (e.g., manufacturing, marketing, sales) and bolster financials (e.g., working capital).1
Chosen carefully, a VC partner can be much more than a source of capital for a startup. Because of their position and breadth of experience with the innovation community, a good VC can see around corners, helping founders avoid pitfalls that take so many startups out of the game. Exceptional VC firms also have a team of performance advisors who guide founders to solve critical gaps, establish fit with the market, hire, build, prioritize KPIs, and measure progress. Working as a partner, the VC provides guidance that helps a startup to secure and scale its business, which is good both for the business and for the LPs who have invested in it.
How VC Works for Investors
For investors, VC provides a chance to put their money into innovative companies with growth potential that are not available in the public markets. Besides diversifying their overall portfolio, these often smaller and earlier-stage companies may offer higher returns than traditional investment vehicles because they allow the investor to get in at a lower cost with a company that is in, or on the cusp of, a rapid growth phase.
What’s more, VC investing is the best way for people to participate in the innovation economy without the challenges that come with becoming a founder (it’s not for everyone!) LPs get to be a part of a group of people that is driving the growth of market-shaping companies. Without their valuable capital, many of these companies would not make it past the traction phase.
VC is a Team Sport
To raise the chances that the investments will yield the greatest possible outcomes for all parties, VCs are strategic about the companies to which they deploy capital. Through industry experience and continuous research, a VC knows what industries are growing well and/or are poised for measurable, competitive progress. They have experience identifying high-growth potential companies and know what differentiates them from those that are not.
While many people who work in VC do so because of a desire to support founders, they are also investing in industries and businesses. Discipline and measured decision-making, informed by experience, data, and detailed analysis, are required for success. The VC firm will often put a member of their team on the portfolio company’s Board of Directors, remaining close with each company, not only to identify support needs and opportunities in real-time but also to track the company’s performance against relevant benchmarks so they can help to keep the investment healthy.
Once the portfolio company is at a size, performance, and credibility state where a successful exit is possible (e.g., via IPO or M&A), the VC sells its equity stake and distributes the returns to the investors. Typically, success is measured by the size of the exit and the speed at which a startup reaches that point.
The Role of VC in Private Market Investing
The innovation economy drives U.S. GDP and wealth creation. For private investors, the ability to participate has become significantly more difficult and expensive over the past decade. Not only are there fewer public companies, but those that do IPO also enter the market at roughly 10x the value (i.e., cost to the investor) than they used to. All of the early-phase, rapid, and highly valuable growth is now happening in the private market – where VC creates opportunity.
In fact, over the last 10 years (ending June 2021), VC has emerged as a more impressive investment vehicle compared with other asset classes, most notably public market and private equity investments into more mature businesses before they go public.2
- Venture capital was the top performer, with average annual returns of 15.15% 2
- The S&P 500 slightly edged out private equity, with a performance of 13.99% per year 2
- Private equity had average annual returns of 13.77% 2
- The Russell 2000 Index had a 10.50% average annual return3
Like all investment categories, VC has ebbed and flowed, and longevity matters.4 Generally, however, LPs have earned an average internal rate of return (IRR) of approximately 20% over the last 50 years (compared to the stock market average of 7-10%).5
Just as it is with seeking a good bank or wise wealth advisor, the VC you choose to work with matters. Look for a firm whose funds have yielded consistent long-term returns above the market average. Talk with the team and review the firm’s portfolio to assess their knowledge of (and success with) high-growth industries and businesses. Confirm that the firm is advising founders, helping them to hire well and engineer performance that accelerates the company toward a successful exit.
To recap, VC is a rewarding form of private market investment that gives innovators a real chance to transform their ideas into businesses. It connects founders and investors, driving progress and successful outcomes for both. And for everyone who is part of this virtuous cycle of funding, building, and scaling market-changing businesses, VC is a way to support the impact of the innovation economy – which is the economy today.
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