What is VC?

A brief history of VC  |  The VC Job Cycle

This chapter is an extended formal definition of venture capital.

The phrase “venture capital” is often used loosely in the mainstream to mean “any funding for any new company.” However, venture capital is a well-defined type of investment class that resides within a broader category called private equity, which essentially means, “part ownership of companies whose stock is not traded publicly.” Here’s my attempt at a somewhat approachable yet specific definition of venture capital, which has three components:

Venture capital is defined by institutional private equity investments in high growth startups. Let’s unpack this, starting with the first word, institutional.

Institutional

This refers to where the money is ultimately coming from. VCs are not investing their own cash, by and large. Rather, they are professional money managers investing other people’s money, mostly from large institutions, such as pension funds, university endowments, banks, insurance companies and other corporations.

These institutions have cash they need to invest, and often they want to diversify their investments beyond traditional public stocks and bonds. They opt to put a small percentage of their portfolio into higher risk investments called alternative assets, most commonly real estate, hedge funds and private equity. Venture capital, again, is a type of private equity.

The money that fuels venture capital is coming from these large, often financial, institutions. VCs are paid a fee plus a share in the profits for managing these funds, and they have a legal obligation (a fiduciary duty) to act in the best interest of these institutions, who are the limited partners (LPs) of the VC fund.

While institutions provide the bulk of the capital that is invested industry-wide by VC firms, LPs do not necessarily have to be institutions. Many new, smaller VC firms will raise their first funds from high net worth individuals. Successful entrepreneurs who start VC firms often prime the fundraising pump with their own capital, demonstrating their skin in the game to potential institutional LPs. Managing dozens of LPs can be burdensome, creating the incentive for firms to recruit fewer, bigger LPs in future funds.

Angels vs. VCs

VCs are often confused in the popular media with angel investors, individuals who invest their own money in startups. Many angels employ investing techniques similar to venture capitalists, though usually at an earlier stage, often called the seed stage. While they have some similarities to VCs, angel investors have nobody to answer to and may choose to invest in a startup for a variety of reasons not connected to financial returns. Angels have no fiduciary duties.

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