Venture Capital: What It Is, How It's Used, and How It Works

Venture capital is the capital that drives innovation.


It acts as an engine for economic growth, and it has become a larger and larger piece of that puzzle over the past several decades.


This article will break down some of the most common questions about venture capital including what it is, how it’s used, and how it works.


โ€˜To learn more about other terms commonly used in venture capital,ย check out our complete VC Glossary.’


What Is Venture Capital (VC)?

What is VC?


Venture capital (VC) is money provided to startups in exchange for an equity stake. It is a type of private equity investment that venture capitalists make in startup companies or early-stage companies that have a high growth potential. This type of capital is typically used as an alternative to traditional forms of financing, such as venture loans, which often come with higher interest rates and higher risk.


A VC firm seeks a stake in the company, which gives them a share of its profits and losses, in exchange for capital. In some cases, venture capitalists may also provide mentorship or advice to help the startup achieve success.

How Do Venture Capital Funds Help Startups?

Venture capital funds help startups in several ways, from providing funding to offering advice and guidance. They can provide the necessary financial resources to cover research and development costs, hire key personnel, launch products or services, and more.


VCs can also offer strategic advice that helps startups make better decisions when it comes to expanding operations, a wide range of business opportunities, and more.

What Are the Different Stages of Venture Capital?

Venture capital funds invest in different stages of a company’s lifecycle based on their risk-reward preference. Here are the most common stages for VC investment.


The pre-seed stage of vc funding is when any outside money is provided to a startup before it has any other kinds of funding. Some investors and entrepreneurs might refer to this as a “friends and family round”, or “bootstrapping.


Asking for financial backing from close contacts who are willing to take a sizable risk on an unproven concept or idea – all before involving external investors.


Entrepreneurs may be ready to bring their idea into the next phase of development when they have identified a clear market and a pathway to that market. Capital is needed to make a few hires and cover the administrative and other expenses is necessary to keep the vision alive.


Find pre-seed investors through Confluence.VC.


At this stage, the entrepreneur has made a few hires, there is a clear path to the marketplace and maybe even some revenue to show. Potential investors are angel investors, friends and family and/or crowdfunding.


Though money gives startups the boost to begin operations or expand current ones – with this comes an exchange for equity that must be factored into initial seed rounds. Companies can attract investors who will provide external capital in exchange for an agreed-upon amount of equity – this amounts to the pre-money valuation.


Valuations typically range from $10M-$20M post-money, but this fluctuates based on market conditions and demand for the round.


Oftentimes, founders have no choice but to relinquish 10% or more ownership as part of their seed round agreement; and those without established cash flow or customers may even be subject to higher percentages of giving away a portion of their business identity.


Find seed investors through Confluence.VC.

Series A

The Series A stage of venture capital is the next round of funding after the seed funding and is an important milestone for growing startups. Now the potential investors are vcs, accelerators and maybe some super angel investors.


After securing seed funding and developing a working product or service, companies can then raise additional capital in exchange for preferred stock. This size of capital raised at this stage differs by company needs, but most Series A rounds are for at least $10M.


Most often between 10% and 30% of their startup’s existing shares are sold off at this stage to get extra cash on board; success rates vary with roughly one-third seeing successful investment into their business from these rounds.


Find Series A investors through Confluence.VC.

Series B

After 12-18 months of Series A funding, companies may still need more capital to reach their goals. This is when they can step up to the challenge and apply for Series B venture financing – a sign that the startup’s been so far successful. But it isn’t always about profits; even some startups that are net negative in terms of profits could have revenue coming in, making them suitable candidates for further investment despite not having consistent profit margins yet.


Find Series B investors through Confluence.VC.

Series C and Beyond

If a company still needs outside financing, this round helps it expand operations, increase revenue and develop new products or services.


The potential investors are late stage VCs, private equity firms, hedge funds and banks. The amount now is significantly higher than earlier rounds since investors are looking for a greater return on their investment.


Find Series C investors through Confluence.VC.

Initial Public Offering (IPO)

A company’s initial public offering (IPO) is a major milestone – it provides an opportunity for established organizations to exit some or all of their ownership, and lets growing startups access much-needed capital.


By selling corporate shares in the IPO process, these businesses can unlock important contributions from both large investors as well as individual members of the general public. Now the potential investors are the public.

Who Can Invest In a Venture Capital Fund?

Not everyone can invest into venture capital funds, and the capital used to operate VC funds comes from institutional investors like endowments, pensions, family offices, and corporations.


Individual investors may also qualify if they have the necessary capital and skill set. To qualify for venture capital investments, investors need to be accredited, which means having the financial means (an annual income of at least $200,000 or at least $1 million in net assets) and experience to assess vc investments, being able to commit a large sum of money for an extended period, and having the expertise to monitor vc investments. Individual investors must also have the professional criteria such as being an investment professional in good standing holding the required licenses,


Although non-accredited investors can also participate, the SEC has limits on how much these investors can contribute over one year which is based on their net worth and income.

How Much Money Do You Need to Invest in a Venture Capital Fund?

The amount of money required to invest in a venture capital fund varies depending on the venture and the vc firm.


Generally, venture capital funds have LP minimum check amounts, or the minimum amount that an LP must invest in order to become a limited partner in the fund. This amount typically ranges from $250,000 to millions of dollars. However, vc firms may accept smaller investments if they believe the limited partner can provide meaningful value outside of capital.

How Is a VC Fund Structured?


    • Venture Capital Firm (Management Company). A management company is an essential part of a venture firm’s operations, providing oversight and control across all the funds. It has key responsibilities such as collecting fees, paying expenses, and owning trademarks that give it exclusive control over its brand name and image. Depending on their size, structure, and makeup these companies are treated differently under US tax laws – single-member entities receive special status while multi-member ones must adhere to partnership rules.

    • General Partner (GP). The GP is in control of managing and operating the fund, filing and signing off on all tax documents, and is liable for the management company’s actions with no limit to their responsibility.

    • Limited Partners (LPs). Investors enter the fund through a limited partnership, such as pension funds, foundations, insurance firms, and wealthy individuals. With this agreement in place, any liability is capped at the amount of capital originally contributed to the fund.

    • Portfolio Companies. These are the companies the venture capital firm invests in.

What Documents Are Needed to Start a Fund?

Starting a venture capital fund requires several documents to be legally compliant and raise capital. Generally, venture capitalists need to include:

Fund documents:


    • Limited Partnership Agreement is the legal bedrock of a fund, detailing how it will operate and setting out the rights of its general and limited partners. It can be standardized for all participants or tailored to specific needs through an additional side letter document. Having this agreement in place ensures that every partner knows their obligations as well as what they are entitled to from the venture’s success!

    • Investment Memorandum that outlines the venture’s investment strategy and key terms of the venture’s offering. This should include any limitations or restrictions on investments, raising materials such as slide decks, a business plan, and financial projections.

    • Private Placement Memorandum providing details about the venture and its offering, such as offering price, risks to investors, and potential return on investment.

    • Operating Agreement that outlines the venture’s ownership structure (including voting rights) and terms of governance. s may also need to complete additional documents and disclosures, such as state blue sky compliance forms.

Deal-specific documents:


    • Term sheet. A term sheet is a document that outlines the terms of an investment venture between a VC firm and a startup or other company looking for vc investment.

    • Stock purchase agreement (SPA). The stock purchase agreement (SPA) is a legally binding document that outlines the terms for the sale of shares in a venture capital fund.

    • Disclosure schedule for SPA. This document outlines the venture capital firm’s intent to invest and exit the venture.

    • Voting agreement. An essential legal document that sets out the rules and regulations for the voting rights of shareholders.

    • Investor rights agreement (IRA). Legal document that outlines the rights and privileges of vc investors.

    • Right of first refusal / co-sale agreement. The ROFR allows the company the first opportunity to purchase the shares of an investor who wishes to sell them.

    • Certificate of incorporation.ย The certificate of incorporation is a legal document that outlines the privileges and rights that come with owning stock in a corporation.

ย Tax documents:


    • Schedule K-1. A Schedule K-1 is a tax document used by venture capitalists to report the income and investments of limited partners.

    • Form 1065, Return of Partnership Income. A tax document is used by vcs to report income and expenses.

How do Venture Capital Funds Raise Capital?

VC funds usually raise money from several different sources, such as venture capitalists, private equity and venture firms, family offices, individual investors, pension funds, endowments, venture philanthropists (social venture capitalists), and other investment vehicles.


Venture capital firms are family offices, vcs, and other funds that invest in high-growth startups. These investors may or may not have a stake in the vc fund itself; however, they can invest their money into the vc fund so that it is managed by the venture capitalists.


Institutional investors such as pension funds, endowments, foundations, and other large-scale investment vehicles usually partner with venture capitalists to create what is called a co-investment vehicle. A co-investment vehicle allows an institutional investor to commit money directly into vc investments without being part of the venture capitalist’s fund.


Angel investors are wealthy individuals who provide early-stage funding for new business ventures.


Family offices are private wealth management companies that invest for a single-family or individual.


Venture philanthropists are venture capitalists who are looking to make social impact investments in addition to financial returns. These venture capitalists partner with non-profit organizations to provide funding and expertise to socially-minded businesses.


The vc fundraising process typically involves the venture capitalist team presenting a business plan or concept to potential LPs. The vc then negotiates terms and raises funds from these sources of funding, usually through a combination of equity (ownership) and debt (loans). As the vc firm grows and matures, offices, venture philanthropists, and other venture capitalists can also invest in venture capital funds.


Once the vcs have raised enough funds from LPs, they will often agree with a venture capitalist firm to manage their investments. This agreement outlines the vc’s responsibilities for managing the venture capital fund, as well as detailing the vc firm’s expected returns on investment and exit strategies.


A vc fund typically aims to maximize returns by investing in businesses that show promise of rapid growth and offer attractive exit opportunities such as initial public offerings (IPOs) or mergers and acquisitions (M&A). The venture capitalist team works closely with portfolio companies to ensure they are structured properly and have access to resources necessary for success venture philanthropists can also help with the vc process by providing advice, mentorship, networking opportunities, and funding.


Ultimately, vcs are looking to maximize returns for their limited partners while taking calculated risks on potential portfolio companies. They work closely with founders to ensure a business concept is viable, manage investments, and act as a trusted advisor throughout the vc process.


By carefully selecting investments and monitoring portfolio companies over time venture capitalists have the potential to earn healthy returns for their investors. And through these strategic investments vcs have been able to fund some of the most innovative startups in recent years that are driving economic growth around the world.

How do Venture Capital Funds Deploy Capital?

Venture capital funds are well-known for their thesis-driven investments, focusing on areas such as stage of development, industry, or even geographic region. This focus helps to frame the initial investment window which can range anywhere from 1 -3 years while they seek out and identify suitable companies in those spaces. Once identified a lead investor will often be assigned who is responsible for negotiating price points and other essential terms before allowing others to join at similar conditions (but not always).

How do Venture Capital Funds Generate and Distribute Returns?

VCs strive to generate returns for investors by orchestrating successful exits from their portfolio companies – either through an Initial Public Offering (IPO), a merger or acquisition, or the sale of shares. Once the VCs pay themselves the agreed-upon fee arrangement (typically 2 & 20 is standard for the venture capital industry) and other applicable costs are considered, limited partners take home around 70-80% of the remaining fund yield.

Venture Capital Fund Management Fees

Sometimes, fees for large funds may only be charged on invested capital or decline after a certain number of years.


VC funds typically charge an annual management fee based on a percentage (2% is common) of committed capital. In addition to this, vc firms also receive a carried interest, usually between 20-30%, of the profits earned by the fund. The venture capitalist firm receives this carried interest only after they have generated returns that exceed expected returns.


Some LPs may receive preferential treatment in the form of lower fees or more favorable terms. For instance, vc funds may waive their management fee for a few years if larger LPs provide capital early on. This is often done to incentivize larger institutions and attract additional investment.

Bottom Line

Venture capital is a powerful tool available to ambitious entrepreneurs with growth potential. By receiving investments from vcs, businesses can utilize crucial resources needed for their development – leading the way toward achieving success and profitability in record time. After these milestones are achieved, there’s often an opportunity for investors (including VCs) to benefit financially by taking advantage of any returns linked early on investment decisions.


What is an example of a VC fund?

FundComb has a list of the largest vc funds in the world. Bain Capital is at the top of the heap with $104B in their fund, followed by General Atlantic with $31B, Hillhouse Capital Group with $30B and Insight Venture Partners with $18B.

How do VC funds make money?

VC funds make money by strategically investing in high-potential companies and earning returns when those investments are successful.


VC firms typically charge an annual management fee based on a percentage (2% is common) of committed capital. In addition to this, vcs also receive a carried interest, usually between 20-30%, of the profits earned by the fund. The venture capitalist firm will only receive its carried interest after they generate returns than exceed expected returns.


VC returns are the profits earned by venture capitalists following successful investments. VC funds strive to generate these returns for their investors by exiting their portfolio companies through an Initial Public Offering (IPO), a merger or acquisition, or the sale of shares.

What is the difference between venture capital and growth equity?

The main difference between venture capital and growth equity is the stage of a company’s development when venture capitalists invest. VCs typically provide funding to companies that are in an earlier stage, while growth equity investors usually come in later and focus on firms with more established companies.


VC investments tend to be higher risk but can have much higher returns than growth equity investments if the venture is successful. Growth equity investments may require less risk, but often have lower returns than vc investments due to investing in mature companies rather than early-stage startups.


Additionally, venture capitalists often look for high-potential opportunities with long-term goals in mind, whereas growth equities may not offer such potential since they are investing in more established businesses with proven track records.

How can I become a venture capitalist?

Becoming a vc requires a combination of education, experience, and skills. A venture capitalist must have at least a bachelor’s degree in finance, economics, or business to work as an investor.


The vc industry rewards strong analytical skills and an understanding of the complexities of financial models.


Experiencing vc from the inside is also an invaluable way to learn the job. Becoming an analyst or associate in a vc firm can provide someone with the on-the-job training and mentorship needed for venture capitalists. It’s also important to network with industry leaders, as venture capitalists need to be able to identify potential investments before everyone else.

How can I pitch venture capitalists?

Pitching venture capitalists is no easy task, and requires a great deal of preparation. To get venture capitalists interested in your business venture, you will need to present a compelling case for investment by outlining the potential returns that can be generated from the venture.


When preparing your pitch deck, make sure you explain the size of vc your target market, the competitive landscape, and the growth potential.


Additionally, you should also include a financial forecast of your venture’s expected ROI over the next 3-5 years. Having a well-constructed pitch deck will help venture capitalists understand how investing in your venture fits into their portfolio strategy. Venture capitalists will be looking for a thorough understanding of the venture’s business model, target market, and competitive landscape.


Additionally, venture capitalists also want to see a well-constructed financial forecast that demonstrates potential returns on investment over the next 3-5 years. Having an in-depth understanding of this information is essential to getting venture capitalists interested in your venture.


Lastly, venture capitalists want to invest in businesses with a solid team behind them, so make sure you highlight the qualifications and experience that set your venture apart from the competition. Showing venture capitalists that you have an experienced and knowledgeable team will give them confidence that their investment is in good hands.


Commonapp.VC is an easy way to pitch hundreds of VCs with one application. Before you submit, read this article on 25 pitch deck mistakes that startups make.

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