Venture Capital

Background

Venture capital has helped fund some of the most industry-disruptive companies of our time, from Airbnb to Google. But those brands weren’t exactly household names when they received their initial VC cash infusions.

By definition, venture capital is a form of investment. Firms use VC to invest in startups and other emerging organizations with high growth potential. In other words, VC firms bet on companies with hopes that they’ll grow into larger corporate powerhouses (more VC basics here). 

How It Works

The lifecycle of VC looks something like this:

Accredited investors, including wealthy individuals, endowments, and pension funds, invest money into a VC firm (or “fund”). The firm then hunts for potential companies that they believe will grow significantly and proceeds to invest some of the aforementioned funding into them. VC firms often give their portfolio companies guidance and strategy assistance in addition to funding.

The manager of the VC firm is called the general partner, or GP, whereas the people investing their money in the firm are limited partners, or LPs.  

In exchange for the funding—which these startups often use to scale part of their business, whether that’s entering a retailer for the first time or launching a new product category—the VC firm receives ownership in the business (called “equity”). 

The LPs pay the firm’s management fees, which are annually around 2% of the total fund (so for a $100M fund, the management fee would be $2M). When a portfolio company gets acquired, the GPs typically get roughly 20% of the profit—called carried interest or “carry” for short—that the VC fund made (learn more about carry). 

These investments are considered highly risky. Roughly 75% of VC-backed companies will fail. That means the other portfolio companies need to provide significant returns to make up for all the companies that don’t yield returns (more details on how these numbers work here). VC firms make multiple investments in different businesses in the fund in hopes that a handful of them are big enough successes to make up for the other low performers.

Origins and Impact

The venture capital industry is relatively new (unless you count the 19th-century whaling industry, which one Harvard professor argues was the basis for the modern VC model—more on that here). 

The first modern VC firm, the American Research and Development Corporation or ARDC, was founded in 1946. It’s best known for investing in companies that utilized technology developed during World War II. The ARDC’s cofounders included Federal Reserve Bank of Boston president Ralph Flanders and Harvard Business School professor Georges Doriot.

Before the ARDC, wealthy families such as the Rockefellers were the economy’s primary “risk investors.” But this new firm proved that larger institutions (such as universities and insurance companies) were willing to take financial risks for the potential of significant rewards, too.

Recent Trends

Venture capital firms like Andreessen Horowitz, Sequoia Capital, and Kleiner Perkins are best known for helping fund some of the buzziest business movements of our time, from the cryptocurrency boom to the current AI craze (see the top 10 VC firms by assets under management).

In the 2010s, many venture capitalists were bullish on direct-to-consumer or DTC brands (find out why). More recently, VCs have seemed particularly excited about AI, with industry leaders like Perplexity and OpenAI both receiving major VC infusions in 2024.

In 2023, US VC investments totaled roughly $170B, falling significantly from the roughly $242B invested in 2022. Experts claim that widespread economic uncertainty contributed to the decline.