The Fine Print on Investing in Venture Capital

So You Want To Be a Venture Capitalist? Join the Party

Investing in venture capital, while often defined in tandem with private equity, is really more like its unpredictable sibling. It’s in the same family but philosophically different in how one approaches the ‘buy low, sell high’ challenge.

Private equity (PE) involves the purchase of established companies, while venture capital (VC) invests in startups — and often in the people behind them.

One might say that today’s VC-backed company may evolve into a PE-owned company someday — but then again, it may not. As the old adage goes: buyer beware.

Nearly thirty years ago, the Harvard Business Review noted Silicon Valley entrepreneurs were thought of as “modern-day cowboys” likening their famous risk-taking to how “earlier Americans explored the West” saying that right next to the unflinching entrepreneur, “stands the venture capitalist, a trail-wise sidekick ready to help the hero through all the tight spots—in exchange, of course, for a piece of the action. “

Although still inherently fraught with risk, today’s venture capitalism isn’t fading away in proportion to the movements of progress like the American cowboy riding into the sunset. Instead, venture capitalism has roped progress at full speed and thrown a saddle on it, riding it into the future.

Turning Back to the Future by the Numbers

Thirty years ago, the Harvard Business Review noted that in 1997, “Venture capitalists invested more than $10 billion.” Fast forward to 2021 and, according to the PitchBook-NVCA Venture Monitor, investing in venture capital hit an all-time high with nearly $330 billion invested (about double from 2019) across approximately 17,000 deals. While that number has declined slightly since, investing in venture capital is still incredibly high with over $130 billion invested as of September 2024 across 11,000 deals.

2021 was also a high point in annual exit value with $774.1.4 billion created by VC-backed companies going public or being acquired. About $681 billion of that was realized through public listings confirming the favorable conditions presented by strong public markets and valuations as well as the availability of SPACs as an alternative to IPOs.

Yet over the past 40 years, the number of public companies available for VC investment has actually decreased by 4,100, even with AI expanding the possibilities of new company emergence and growth. Despite the decline, venture capitalists may still have opportunities to invest — if they’re willing to take the risk.

Liberty Street Funds Chief Investment Officer Christian Munafo says that regulations and volatility are to blame for the drop-off, not the quality of the investments: “If your average company in the ’90s would go public in about four years from inception, much younger in its development, those companies today are staying private for 10, 15, 20 years,” says Munafo, “Because they have that access now to private capital. And so they’re scaling now inside the private markets, outside the listed markets.”

According to the DWF group, “VC investments usually have a higher risk profile with the target often having little (or no) track record of profitability but are in need of a cash injection to achieve the next stage of growth. In contrast, PE funds traditionally invest in more mature companies to reduce inefficiencies and drive business growth through increased margins, new sources of revenue and bolt-on acquisitions.”

Overall, however, VC opportunities are growing — it just depends on where you look, and more places to look are cropping up. But one man’s ‘opportunity’ is another man’s ‘obstacle,’ depending on how long you can wait to cash out. That, too, is changing.

In 2021, the venture ecosystem observed a sharp uptick in valuations across all stages of the investment cycle. However, the Wall Street Journal reports that in 2024, “U.S. venture firms returned $26 billion worth of shares back to their investors, the lowest amount since 2011. Startup investors say 2024 has continued the trend, with high levels of investment and few acquisition deals or initial public offerings…The decline is particularly notable because the past three years have been the highest three on record for total VC firm investments since 1998.”

Bottom line: If you’re ready to step into VC — timing is everything.

Time Is Money: Investing in a Startup at Different Stages

Venture investments require long hold periods, typically at least 5 years. Therefore, before you invest in one, you need to be prepared to tie your money up for a long time. Since it takes time to select and execute investments on the front end and sell, or ‘harvest,’ investments on the back end, you should prepare to have any money you invest in a VC fund tied up for at least 10 years.

Jake Miller, Co-Founder and Chief Solutions Officer at private markets platform Opto Investments, says it may take even longer, noting that investors should be ready to hold over time rather than cash out quickly: “Investment timelines range from eight to 12 years for early stage to three to five years in late stage,” says Miller speaking to InvestmentNews.com. “So investors need to be comfortable with the conditions of putting dollars to work today and partnering with a VC for at least that time period, rather than chasing VC because of today’s positive IPO headlines.”

Even so, “Recent Federal Reserve interest-rate cut—could spur a rebound in public listings,” reports PitchBook.

A VC fund is the most typical way to invest in a startup and, depending on the strategy of the fund, your money may go in at various stages of development.  This, in turn, will affect how long you wait to realize returns. In “Financing Startups,” law firm TK Partners, summarizes the stages of investing in venture capital:

1. Start-Up Stage

Newly formed companies without significant operating histories are considered to be in the pre-seed. Most entrepreneurs fund this stage of a company’s development with their own funds as well as investments from angel investors.

Angels are wealthy individuals, friends, or family members that personally invest in a company. Angel investing is typically reserved for established businesses beyond the startup phase, according to The Hartford. They often will back companies that are at the concept stage and have a limited track record with respect to customers and revenue. These investors tend to invest only in local companies or people that they know personally.

According to The Exits Factor, the risks are significantly higher in the early stages — but the rewards can be too, saying, “Seed funding allows investors to get in at the ground level, often at the lowest valuation of the company.”

2. Seed and Early-Stage Funds

TheBusinessProfessor.com says seed or early-stage rounds often involve investments of less than $5 million for companies whose promising concepts are validated by key customers but have not yet achieved a break-even cash flow point. That is the lowest amount of income needed to ensure that production costs equal revenues.

Organized groups of angel investors, as well as early-stage venture capital funds, usually provide these types of investments. Typically, seed and early venture capital funds will not invest in companies outside their geographic area (usually 100-150 miles from the VC’s office) as they often actively work with management on a variety of operational issues.

Seeding the Seeds

The Exits Factor notes that opportunities for investment may also exist before the seed stage, called ‘pre-seeding,’ saying, “This round of venture capital serves as the first institutional capital injection, supporting the founding team in finding product-market fit, hiring early employees, and testing go-to-market models. It has become a crucial phase in the startup funding ecosystem, offering a bridge between ideation and formal seed funding.”

Typically, says The Exits Factor, these pre-early-stage rounds attract three types of investment cash:

• Angel Investors: High dollar amounts up-front before the details are fully hashed out.
• Accelerators/Incubators: Works in tandem with development stages.
• Dedicated VC funds: A new industry standard of money set aside specifically for this stage.

3. Growth Stage Funds

Growth stage funds, focus on companies that have a proven business model. These companies are either already profitable or offer a clear path to sustainable profitability. These investments tend to be in the $5-20 million range and are intended to help the company significantly increase its market penetration.

In the past, startups had to go public much faster in order to expand cash flow, but with money more readily available from the private sector, growth stages can take more time to grow. This increases the strength of a company for the day when the IPO comes — if it comes at all.

According to the Wall Street Journal, “Venture firms themselves have made IPOs less necessary. Many have swelled in size in recent years, allowing them to bankroll startups indefinitely while also buying out employee shares in so-called tender offers.”

The evolution of Artificial Intelligence has brought huge gains for PE and VC investors, says the Wall Street Journal. In fact, “There are currently more than 1,400 startups valued at $1 billion or more—so-called unicorns—according to a recent presentation from Coatue. All have investors waiting to get rich.”

The pool of potential venture capital investors is very robust for growth-stage investments, with firms across the United States willing to participate in investment rounds at this stage. Growing trends in how quickly companies reach Unicorn status highlight the importance of investing in earlier stages.

4. Late-Stage Funds

Late-stage venture capital investments tend to be for relatively mature, profitable companies seeking to raise $10+ million for significant strategic initiatives (e.g. investment in sales and marketing, expansion overseas, major infrastructure build-outs, strategic acquisitions, etc.) that will create major advantages over their competition.

These opportunities are usually funded by syndicates of well-established venture capital firms that manage large funds. Late-stage VC has risks, but not like you’ll get in the beginning stages — even so, risks are risks in VC.

“Naturally, seed and early-stage startups have higher loss ratios than mature companies,” says Pitchbook. “But even for later-stage bets, the stifled exit market has led to higher rates of disappointment. Among companies that raised a Series D and beyond, a majority of exits since 2022 were at a loss.”

Although declines have been seen in every stage of a startup’s valuation, TechCrunch notes that late-stage declines, which are affected the most by downward trends that have emerged since 2021, aren’t necessarily a bad thing depending on the stability, growth, and scale of the company.

The timeline for identifying failures moves faster in the later stages, says TechCrunch, allowing investors and markets to “recycle human capital faster than overfunded startups that end up as expensive zombies.”

The good news is that late-stage VC isn’t dead, it’s just undergoing a reorganization of priorities in a tough market — what’s old is new again.  It means that running with more stable companies could be an antidote to being shut out of increasingly private late-stage investing in startups that are still learning to walk.

5. Buyouts and Recapitalizations

During a CNBC-moderated panel, general partner at Race Capital Edith Yeung mentioned, “In the VC world, it’s really all about liquidity stupid.”

Buyouts and recapitalizations are becoming more prevalent for mature technology companies that are stable and profitable. In these transactions, existing shareholders sell some or all of their shares to a venture capital firm in return for cash. These venture capital firms may also provide additional capital to fuel growth in conjunction with an exit for some or all of the company’s existing shareholders. However, no matter the stage of investing in venture capital, if a VC fund turns out to be profitable in the end, the investor is not the first person to see returns when they come in.

It was mentioned at the same CNBC panel that with a lull in the IPO market and significant growth in the private market abuzz with AI opportunities, liquidity is harder to achieve. The panel also agreed that AI has led to massive growth privately, but not publicly, squeezing out some investors. According to Reuters, “Limited liquidity has driven investors to negotiate tougher terms for startups, leading many to postpone funding until conditions improve.”

Larry Aschebrook, founder and managing partner at late-stage VC firm G Squared, told the panel that it is time to explore growth apart from AI in sectors like crypto, cybersecurity, and enterprise software to try and produce liquidity from a new crop where opportunities for VC investments may be more robust.

Fees You Will Pay When Investing in Venture Capital Funds

The returns a venture capital firm earns on its investments are generally referred to as its ‘gross returns.’ Net returns, however, are what count. Net returns generally refer to the returns actually made by a VC fund investor. It’s crucial for a fund to return twice its investment.

Before investors see returns, the VC fund takes a management fee, as well as carried interest or ‘carry fee’ on any profits. Some funds take a 2% management fee and a 20% carry fee, but larger funds may take a 1% management fee with a 30% carry.

The good news is that if the fund doesn’t become profitable, no carried interest is paid, so incentives are pretty well aligned. That said, VC funds are paid management fees, regardless of performance, intended to cover overhead. These fees vary widely, but a good-sized fund can yield very good salaries to fund managers — and that’s just the management fees.

Your Due Diligence About a Fund

So, you are new to investing in venture capital and are considering making an investment for the first time. Your first fundamental option along the decision tree is whether or not to do it. To fully inform your decision-making, you must first weigh risks against the rewards, and the timing against the market temperature.

Your next fundamental decision is: Will you make your own investment decisions, or will you invest in a VC fund? If you decide to go it alone, you may want to join an angel group. Before you do, evaluate whether or not you are cut out to be an angel — or the cowboy, as the case may be. Everyone can sustain the wins, but can you sustain the length of the journey and its potential losses? If this is the way you decide to go, you need to learn how to walk the walk of an angel investor so you don’t trip up.

If, on the other hand, you prefer to put your money in the hands of a professional to manage investing in venture capital for you, select that professional intelligently. Before you invest in any fund, it is important to understand the legal relationship that will exist between you and the fund once you invest. You, and/or your lawyer and/or accountant, must review the fund’s limited partnership agreement.

Is VC for You?

As in any other investment class, there are winners, losers, and those that fall everywhere in between. As new funds and angel groups enter the space, whether it be in tech or health care, AI, or cyber, investors need to be more vigilant than ever in doing their due diligence as the landscape of the market, the companies, and the laws continue to evolve at the speed of progress.

If you are a first-time investor looking to invest in a startup, educate yourself about investing in venture capital and come into the space with a mindset to look before leaping. If you do not take time to gain that crucial insight, you may as well visit the nearest convenience store and buy a stack of lottery tickets where you’ll have a greater chance of winning big.

We think you’ll also like:

1. Should You Co-Invest? 10 Considerations for Co-Investment SPVs
2. The Term Sheet: An Overview of Investor Rights and Controls in VC Investments
3. Laws of Attraction: Can a Conservative Investor Love Venture Capital?

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Structuring and Planning the M&A Transaction
2. Raising Capital: Negotiating with Potential Investors
3. Crowdfunding from the Start-Up’s Perspective

This article was originally published on September 30, 2013 and updated on June 6, 2019, and August 9, 2022.]

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