What is venture capital and how does it work?

Today, there is increasing discussion of venture capital and private equity, two central instruments in the alternative investment universe. Both operate outside public markets but target companies at different stages of their life cycle.

In particular, venture capital focuses on startups and young, yet unlisted companies, often in their infancy but with high growth potential. It is precisely this potential, combined with a high risk component, that distinguishes VC from private equity, which instead invests in more mature companies.

In recent months, partly due to the gradual recovery of post-2023 markets and the impetus provided by generative artificial intelligence and the green transition, interest in venture capital has grown again. For startups without access to bank credit or regulated markets, venture capital often represents the only financial leverage for rapid scaling. However, precisely because investments are made in companies whose viability remains unproven, the risk for investors remains high. Understanding the dynamics of this instrument therefore requires not only attention to the expected return, but also awareness of the inherent uncertainty.

The definition of Venture Capital

Venture Capital (VC), or risk capital, is a form of financing primarily aimed at startups and innovative companies with high growth potential but characterized by a high level of risk. Unlike traditional bank financing, venture capital does not require collateral guarantees, but rather involves the venture capitalist’s entry into the company’s share capital, generally through a minority stake. The goal is to support the business’s development to a stage of maturity, with a view to a future exit—through a sale of shares or an IPO—that allows for a significant return on investment.

According to the Cambridge Dictionary of Finance, venture capital represents:

"capital provided to emerging companies with significant growth potential but which cannot access traditional financing due to their unstable structure or lack of credit history."

The main phases of VC intervention are divided into seed capital, early stage, and expansion stage, depending on the company’s stage of development.

Venture capital funds, often managed by specialized firms, select companies to invest in through a rigorous due diligence process, evaluating business plan, team, scalability, and market potential. According to data from the European Investment Fund, venture capital investments in Europe exceeded €75 billion in 2023, with strong growth in the deep tech, fintech, and life sciences sectors.

Despite the high risk, VC plays a crucial role in the innovation ecosystem, enabling the creation and growth of companies that, without this capital, would struggle to develop cutting-edge technologies or revolutionary business models. As the Harvard Business Review emphasized, "venture capital is one of the main drivers of modern economic innovation."

The difference between venture capital and private equity

Although venture capital and private equity both fall into the category of risk capital investments (equity investments) aimed at unlisted companies, it is important to emphasize that they are two distinct instruments, with different purposes, operating methods, and corporate targets.

The main distinction concerns the company’s development stage in which the investor intervenes. As mentioned, venture capital typically targets startups and early-stage companies, i.e., newly established businesses, often still validating their product or business model. In these cases, the investor assumes a very high risk, offset by the possibility of significant returns in the event of rapid growth or a successful exit.

Private equity, on the other hand, invests in more mature companies that already have a consolidated organizational structure, stable revenue, and sometimes even proven profitability. Here, the objective is often the reorganization, expansion, or acquisition of the company, with a more industrial and less speculative approach. Private equity transactions may also include buyouts, growth capital, or turnarounds.

Another distinguishing feature is the size of the investment: while venture capital rounds (especially in the seed or pre-seed stages) can start from a few hundred thousand euros, private equity manages much larger transactions, sometimes involving tens or hundreds of millions.

Both are therefore essential to the development of the real economy, but they operate at different times and with different strategies throughout the company life cycle.

The Risks of Venture Capital

Venture capital, being a form of investment primarily aimed at startups and early-stage companies, carries particularly high intrinsic risks for both the beneficiary company and the investor.

For the company receiving the funding, the challenge is twofold. On the one hand, it must demonstrate that it can live up to the expectations generated by the capital raised by rapidly developing its product or service, gaining market share, and building a sustainable business model. On the other, it must avoid exhausting available financial resources before reaching the autonomous growth stage or a new investment round. In this context, venture capital often represents the only real opportunity for scaling, and its poor management can irreparably compromise the company’s future.

From the investor perspective, risk is represented by the high uncertainty related to the startup’s success. Many early-stage companies fail to overcome market, technological, or internal management challenges, which can result in the total or partial loss of invested capital. Furthermore, the illiquid nature of the investment—with exits often in the medium to long term—increases risk exposure.

To mitigate these uncertainties, venture capitalists adopt portfolio diversification strategies and, more importantly, often obtain governance rights within the companies in which they invest. This active participation allows them to influence crucial strategic decisions, closely monitor development, and, if necessary, intervene to correct course, thus reducing the inherent risk of investing.

Despite these precautions, venture capital remains a high-risk but high-potential instrument, intended for those willing to support a growth path characterized by uncertainty but also by great opportunities.

Venture capital, how does it work? Players, process, and outcomes

In the world of venture capital, funding for startups and small innovative businesses comes primarily from two categories of investors: venture capital firms and so-called angel investors.

• venture capital firms are specialized companies that manage funds dedicated to supporting entrepreneurial projects with high growth potential. Internationally, there are trade associations such as the National Venture Capital Association (NVCA) in the United States, which bring together hundreds of funds and institutional investors working in the sector.
• Angel investors, on the other hand, are wealthy individuals, often successful entrepreneurs or professionals who provide equity capital and expertise to support startups in their early stages.

These investors share some key characteristics: they tend to favor startups with a strong management team, a detailed and scalable business plan, and clear market potential. Furthermore, they often prefer to invest in sectors in which they have specific experience or knowledge, allowing them to provide strategic support in addition to capital.

The Investment Process

To attract the attention of venture capital firms or angel investors, a startup must first develop a structured and compelling business plan, outlining its business model, target market, growth strategy, and financial projections. If the project piques interest, a in-depth due diligence phase begins, during which investors analyze the company in detail: they verify the viability of the product or service, evaluate the management, and examine the startup’s financial situation and operating history, if available.

After successfully completing this phase, investors decide whether to proceed with financing. If successful, the investor requests an equity stake in the company, often accompanied by an active role in governance or the board of directors, given that the company is not yet publicly traded.

The Outcome of Venture Capital

The venture capital process can end in two main ways: success or failure. In the case of success, the startup achieves its intended growth and development objectives, allowing the investor to realize its return. This generally occurs through a structured exit, such as an IPO, the sale of shares to third parties, or the buyback of the stake by the founding partners or new investors.

In the case of failure, investors face the real possibility of losing their invested capital and decide to divest. Abandonment can occur through the sale of shares to new or existing shareholders or, more rarely, through other restructuring or liquidation operations.

Original article published on Money.it Italy. Original title: Cos’è e come funziona il venture capital?