Venture capital: definition and how it works
Venture capital explained: who funds whom, how a fund works and what it means for a founder.
Venture capital is a form of private equity that finances young, innovative companies in exchange for a share of their capital. The fund does not lend: it becomes a shareholder, and only gets its money back if the company gains value and is then sold or listed on a stock exchange.
How a venture capital fund works
It raises money from investors
Institutions and wealthy individuals entrust it with capital for a defined period, often many years.
It invests in a limited number of companies
Each company is chosen after an in-depth analysis (due diligence) of the team, the market and the product.
It supports the companies
A seat on the board, introductions, help with hiring and with the following financing rounds.
It looks for an exit
A sale of the company or a stock market listing, which allows the capital to be returned to the fund's own investors.
What a fund expects from a company
- A large enough market for a successful company to be worth far more than its entry valuation.
- A team able to execute, with complementary skills.
- Traction: users, customers or revenue showing that the product meets a need.
- A credible exit prospect within the fund's horizon.
What it means for a founder
- Dilution. Each financing round gives up a share of the capital: see how it is calculated with pre-money and post-money.
- Rights for the investor: a board seat, regular reporting, special rights in a shareholders' agreement.
- An expected growth pace faster than that of a company funded by its own revenue alone.
- A real risk for the investor: many financed companies fail, which explains the demands on the terms of the deal.
Venture capital or other sources of funding?
| Source | What you give up | Who it suits |
|---|---|---|
| Venture capital | A share of the capital | Companies with high growth potential that accept dilution |
| Business angels | A share of the capital, often at an earlier stage | Seed-stage projects that also want support |
| Bank debt | Nothing from the capital, but repayments | Companies with revenue to repay |
| Equity crowdfunding | A share of the capital, spread across many investors | Projects that also want to build a community |
Venture capital does not suit every company: it assumes you are aiming for strong growth and an exit. A profitable, stable company will often do better elsewhere.
Before contacting a fund, measure where you stand: a clear file, a clean cap table and answers ready for the usual questions change the quality of the first conversations.