Venture capital firms (VCs) help finance innovative companies.

Combining money raised from their clients with their own, VCs make calculated bets on early-stage companies whose businesses have the potential to change the ways we live and work. 

VCs may therefore make an important contribution to economic growth and progress. 

Many of the household names in today’s technology industry – from social media giants to internet search engines to online payments operators – began life as start-ups that got funding from VCs.  

Let’s look at VC in action.

VCs employ a private equity strategy. They provide capital to companies that are privately owned.

To do so, they mostly raise money from outside investors. 

These investors – known as “limited partners” may be ultra-high net worth individuals or their family offices. 

Or, they are often large institutions such as pension funds who wish to diversify their portfolios from equities and bonds.

VCs go through a fundraising process every few years, raising money from limited partners for their newest fund. 

As we’ll see, risks also include a high chance of losses on many of the underlying investments, illiquidity and loss of the entire value of the fund.

Once a VC has raised enough for a particular fund, it closes it to any further investment and starts putting the money to work. 

It’s common for VCs to buy small stakes in many different businesses to spread their risk. 

And for good reason. Many VC-backed ventures fail to make money for investors in the fund. 

That’s why VCs are structured with the expectation of losing money on most of investments.

Instead, they seek to make large returns on just a few companies, which may more than make up for their many more positions in firms that don’t work out. 

However, VCs may fail to offset their numerous losses with positive returns elsewhere. As such, VCs are only for suitable investors who can bear the loss of their entire investment.

They typically have little control over the underlying investments chosen by the fund’s managers, aka general partners.

Other risks for limited partners include illiquidity, as we’ll see, and less transparency than they might have as shareholders in public companies.

Once they’ve chosen to invest in a firm, VCs try to help promote its growth. 

That’s why they often focus on specific sectors where they think they can add value.

For example, a venture capital firm may concentrate on companies at the cutting edge of medical science as they attempt to come up with tomorrow’s treatments and wellness technologies. 

As well as certain industries, VCs also tend to choose investments based on their stage of development.

These stages range from “seed” – providing capital to companies in their infancy – to “late-stage” – where they are financing businesses that have already generated substantial sales and is looking to expand further.

Because of this specialization, VCs bring not only funding to the companies they back but also knowhow. 

They may advise on business strategy, help introduce them to customers and suppliers and assist in recruiting executives to boost the business. 

If all goes well, the startups may grow, and so should the VC’s investments – on paper at least.

But the VC ultimately needs to be able to cash out: a typical fund comes with the objective that its limited partners will get their money back within ten years. That said, the terms of each VC vary and investors need to be aware of their specific fund’s objectives and strategies. 

So, toward the end of that timeframe, you’ll get VCs pushing for an “exit”. 

That normally translates as either an acquisition – where the startup is sold to some other company – or as a stock market listing, which allows the VC to sell its shares to other investors.

This could also be a failure to do either, resulting in the loss of their investment for the VC investors. 

Whatever the exit, the VC fund’s investors want to achieve the objective of the investment. 

As for the VC managers, they may typically have some of their own firm money in the fund. 

Plus, they may charge an annual management fee and a cut of the fund’s profits above a pre-set level. 

VC investors should read the fund offering material carefully to understand all the fees and expenses being charged.

VCs are always on the lookout for the next big thing, often investing in companies before anyone’s ever heard of them. 

They spend much of their time generating leads, keeping up with developments, and trying to make themselves attractive to startups. 

That means building a strong brand, a good reputation, and a sprawling contact network to spot the next potential opportunity.

Because VCs are hunting for outsized returns, they won’t invest in just any startup: VCs may look for those they believe have potential to return many times the initial investment. 

Typically, that’s companies operating in growing markets – ideally with the ability to scale fast. 

It’s no wonder that tech companies – which can grow incredibly quickly with little capital – are a strong favorite.

A startup’s ability to grow fast comes down to much more than having a good idea – in fact, that’s far from enough. 

What really matters is its ability to execute that idea. 

There’s an industry adage that says it’s better to back a bad idea with a good team than a good idea with a bad team. 

That’s why VCs do due diligence on managers, founders, and engineers to work out whether a company has the team to make its idea a success.

VCs will spend time assessing a startup’s revenue potential by looking at the total value of the market it operates in – known as its “total addressable market” (TAM) – as well as the percentage of that market the company can reasonably expect to capture. 

To figure out the latter, VCs will look at the product’s competitive advantages – including patents, industry connections, and network effects – that might ward off competitors. 

They’ll also evaluate risks that might prevent the product from succeeding, like legal, financial, or technical challenges.

VCs apply financial models to estimate how much the company might be able to make. 

At the early stage where VCs usually invest, there are so many unknowns that it’s next to impossible to get this right more than some of the time. 

But models are nonetheless essential for valuing a business and thus paying a realistic price for the investment.

Despite their potential portfolio benefits, VC strategies certainly aren’t for everyone.

VC strategies are typically only available to suitable investors with sufficient wealth, understanding and appetite for risk.

Many of the underlying companies that VC strategies invest in fail to make a good return. It is quite possible for VC managers not to pick enough winners to cover the losers.

Liquidity is another big factor. A typical VC will require investors to lock up their money for several years.

Exiting a fund prior to the end of its lifetime may not be possible. Even if it is possible, investors may have to accept a much lower price than they paid to enter the investment.

Even if you are a suitable investor with sufficient wealth, that’s not to say a VC fund will necessarily accept your money or that the investment is for your objectives and risk tolerance.