How Venture Capital Works

How venture capital funds invest in risky young companies, why a few big winners pay for many failures, and the role it plays in innovation.

Young technology companies usually cannot get bank loans. They have no profits, few assets to pledge and a high chance of failure. Venture capital fills this gap. Venture capital funds invest in risky start-ups in exchange for a share of ownership, called an equity stake, hoping that a few will become very valuable.

How a fund works

A venture capital fund raises money from investors such as pension funds, university endowments and wealthy individuals. The fund’s managers pick start-ups to invest in, often over several years, and help them grow by joining their boards and offering advice and contacts. Funds usually aim to return money to investors within about ten years, when start-ups are sold to other companies or listed on a stock exchange.

Start-ups typically raise money in funding rounds, often named seed, Series A, Series B and so on. Each round sells a new slice of the company at a price that reflects its progress.

The power law

Venture capital returns follow what investors call a power law. Most start-ups fail or return little. A small number succeed spectacularly, and those few winners generate most of a fund’s profit. A fund might invest in 30 companies, lose money on 20, roughly break even on 7, and make enormous gains on 2 or 3.

One winner pays for the rest

A fund invests 1 million dollars in each of 20 start-ups. Fifteen fail completely, and four return their money. One becomes a huge success and its stake is eventually worth 60 million dollars. The fund invested 20 million dollars and gets back 64 million. Almost all the profit came from one company.

Why it matters, and its limits

Venture capital has backed many of the world’s most influential companies, especially in software and biotechnology. Research by economists including Josh Lerner suggests venture-backed firms are significantly more innovative than similar firms without such backing.

But venture capital has limits. It favours businesses that can grow extremely fast, which suits software more than, say, new materials or energy projects that need long timelines and large factories. It is also highly concentrated in a few regions, and studies show that women and some minority founders receive a small share of funding.

Thinking venture capitalists expect most bets to pay off

Venture capitalists know most of their investments will disappoint. They look for companies that could become huge, accepting that many will fail. A start-up that grows into a steady, modestly profitable business may be a success for its founders but a disappointment for a venture fund.

Key takeaways

Venture capital funds invest in risky start-ups in exchange for equity stakes.
Start-ups raise money in rounds, each selling a new slice of ownership.
Returns follow a power law: a few big winners generate most of the profit.
Venture capital fuels innovation but favours fast-growing sectors and a few regions.