As every business owner knows, innovation and entrepreneurship are the engines of the U.S. economy. Small businesses created nearly half of the country’s gross domestic product in 2020. One corollary to that fact is the growth in the number of people who want to know how to invest in venture capital.
Starting a new company or bringing a new idea or product to the marketplace requires money. If innovation and entrepreneurship are economic engines, venture capital is the lubrication that starts the wheels turning and keeps them going.
For small businesses or startup companies in emerging industries, venture capital is usually provided by high net worth individuals (HNWIs) – also often known as angel investors – and venture capital firms. While venture capital firms make up the lion’s share of activity – $156 billion in 2020, despite the pandemic – angel investing in startup companies is growing.
Angel investors made investments totaling $25.3 billion in 2020, a 6 percent increase over 2019, according to a report by the Center for Venture Research at the University of New Hampshire.
Recent changes in law have made it easier than ever for individuals to take advantage of investment opportunities in startups without having to become a venture capitalist.
What is venture capital investing?
Venture capital investing is putting money into early stage companies or startup companies that show potential for long-term growth. The people who make these investments are known as venture capitalists (VCs). Venture capital investments are made when a venture capitalist buys shares of such a company and becomes a financial partner in the business.
VC investing is a subset of private equity, a form of business financing that takes place away from the glare of the publicly traded financial markets. Private equity investors raise pools of capital from limited partners. When they’ve achieved their fundraising goal, they close the fund and use their money to buy an entire company or a controlling interest. Private equity is all around us: PetSmart, Ancestry.com and Arby’s are among the well-known companies back by private equity.
Although venture capital is a form of private equity, they have significant differences. Private equity typically buys mature companies, while venture capital is given to younger businesses that are earlier in their growth curve. And whereas private equity takes a controlling interest in a company, venture capitalists typically hedge their bets by investing in a number of companies so that if one goes belly up, they haven’t lost everything.
So, what makes a venture capitalist, and how does that differ from an angel investor?
An angel investor is typically a high net worth individual who invests their own money in startups or companies in the early stages of development in exchange for an equity stake. (Think “Shark Tank.”) Most angel investors look to invest in companies that are well-managed, have a fully developed business plan and are poised for substantial growth. These investors tend to fund ventures in the industries or business sectors with which they are familiar.
Venture capitalists (VCs), meanwhile, are employed by risk capital companies that invest other people’s money into young businesses that are usually past the start-up phase. As the name implies, risk capital companies seek high-risk, high-reward opportunities.
Risk is the name of the game when it comes to the venture capital industry. For every 10 startups, three or four will fail completely. Another three or four either lose money or return only the original investment, and one or two produce substantial returns. Investors need sufficient liquid assets to absorb such losses.
Tell me how venture capital works
Venture capital funds are money management organizations that raise money from various sources (such as institutional investors, university endowments and qualified investors) and put that collective capital into young companies that already have some track record of success.
Investors pay the VC firms not only for managing their money, but also for their expertise in identifying high-growth opportunities.
Venture capital funds tend to avoid both the early stages of a company’s development, when technologies are uncertain and market demands unknown, and the latter stages, when competition and consolidation take their toll and growth rates slow dramatically.
The investors in a VC fund become limited partners (LPs), who are critical to the success of venture funds because they put the “capital” in “venture capital.” Similar to how hedge funds operate, limited partners are not involved in the operation of the fund itself. That is left to the managing and general partners of a venture capital firm.
Depending on how the fund is structured, only accredited investors or qualified purchasers can become limited partners in a venture fund.
How do I invest in venture capital?
A qualified purchaser is an individual with $5 million or more in investments. However, becoming an accredited investor has become easier under modernized regulations issued in 2020 by the Securities and Exchange Commission (SEC).
To be an accredited investor, an individual must have a net worth of more than $1 million or $200,000 in income. For joint accounts, the numbers are $2 million in net worth or $300,000 in income. Under the SEC’s broader definition, accredited investor now includes those with “defined measures of professional knowledge, experience or certifications in addition to the existing tests for income or net worth.”
Venture capital investing, however, is no longer just for the affluent. There are a variety of funds, stocks, venture capital debt and direct investments that allow a not-so-deep-pocketed investor to participate in the development of new companies.
To take just one example, the business development firm Hercules Capital was founded in 2003 with the aim of funding ventures and providing an alternative investment vehicle. The firm today has made over $12.8 billion in capital commitments to over 540 emerging growth companies. It trades at around $18 a share with a dividend yield of 7.5 percent.
In 2015, the Jumpstart Our Business Startups (JOBS) Act opened the doors of venture capital investing even wider. It allows entrepreneurs to access capital by crowdfunding through an SEC-registered intermediary. Investors can put in up to $2,000 a year, depending on income or net worth. Online portals have sprung up that vet startups seeking funding and then provide those opportunities to investors. Different portals offer different minimums, but some have investments for as little as $100.
A few examples:
- SeedInvest: Offering a diverse selection of companies to its 600,000 investors, SeedInvest says its lower minimums allow an investor to diversify “like a pro.”
- AngelList: Investors can invest in managed funds as well as in individual companies.
- FundersClub: Accredited investors get access to a global community of founders and investors.
- Indiegogo: Live crowdfunding campaigns back innovative products that investors have early access to.
Venture capital investment returns
A venture capital investment pays off when the new company being funded is successful enough to return the initial investment plus interest and the equity grows in value. Occasionally, a venture capitalist hits a home run (Facebook, Alibaba and Coinbase for example) and the resulting returns make up for a lot of losses.
The risks of investing in venture-backed companies are much greater than investing in public companies. For that reason, VC funds need to outperform the public stock markets. Also, the management fees are significant and the investor’s money is tied up and illiquid for longer holding periods. And, because of the failure rate of new businesses, losses can be substantial.
The National Bureau of Economic Research says the average return on a venture capital investment is 25 percent, and most venture capitalists expect to receive at least that and much more. A 2020 working paper by the bureau reported that half of all VC funds outperformed the stock market, which has made VC investing more attractive. But given the run-up in the stock market, the edge enjoyed by VCs has shrunk.
Is venture capital investing for you?
VC investing can be an attractive addition to your portfolio. For risk-averse investors, allocating a modest 1 percent to 3 percent of assets may be prudent. More aggressive investors with higher risk tolerance might be comfortable with 5 percent to 15 percent.
There are so many factors to consider. What are your investment goals? What is your tolerance for risk? How long can you have assets tied up in venture capital? Which capital investment firm is the best choice for you? Should you only dabble in crowdfunding?
That said, venture capital investing can be exciting, too. You can choose to invest in startups that align with your personal values and priorities, or in one that seems to have the next cool gadget.
The best course of action for those interested in entering the venture capital world is to consult with a financial advisor who understands not only the venture capital landscape, but also the goals and priorities of the investor. The advisors at Cope Corrales take the time to listen to and understand their clients and can help you explore whether venture capital investing is a good move for you.