What Is Venture Capital (VC) — The Structure of Startup Investing

Venture capital (VC) means investing in startups that have just begun—that is, early-stage companies that aren't yet listed.

Startups usually have ideas and teams but lack money. VC supplies funds to such companies and receives equity (shares) in return. Then, when that company grows greatly and goes public (IPO) or gets acquired by another company (M&A), it sells the equity it held to book a return.

The key is that 'the risk is very high.' Most early startups fail. Yet the reason the VC industry keeps running is that a successful few earn enough to overwhelm the losses of the failing many.

The key to understanding VC is the 'power law.'

Ordinary investing has the sense of 'earn a little on average,' but VC is different. Most of the companies invested in disappear without even recovering the principal, and a tiny few mega-hits produce most of the fund's total return.

The typical shape of a VC portfolio is this. Of 10 companies invested in, roughly 6 shut down, 3 get acquired at a modest level, and only 1 achieves a meaningful big success. In fact, various analyses have shown that the top 10% of investments produce 60–80% of the entire industry's returns.

So VC is closer to a game of 'accepting failure and aiming for exactly one home run.' It's not a method of hitting many singles, but a structure of taking many strikeouts while going for a grand slam.

Startups receive investment several times as they grow. Knowing these stages makes the news much easier to read.

Seed: The idea/early-product stage. It has the highest risk, but if it succeeds, it's the stage with the largest return multiple.

Series A: The stage where the product is somewhat validated and the business is scaled up in earnest.

Series B, C, and beyond: The stage where a company already on a growth track receives larger funds for market expansion, overseas entry, and so on.

Finally, when the company goes public or gets acquired, the VC that invested early sells its equity to recover funds (exit). The higher the stage, the more mature the company and the lower the risk, but the smaller the return multiple you can expect accordingly.

VC investing carries two big risks.

First, a high failure rate. A large share of early startups stop before advancing to the next stage. In one survey, of startups that received seed investment in early 2022, only 15.4% reached Series A within two years (a sharp drop from 30.6% in 2018). There is also an analysis that about 75% of startups that received VC investment failed to return cash to investors.

Second, illiquidity. Startup equity cannot be sold anytime like listed stocks. It's hard to cash out until the company goes public or is acquired, and reaching that point can take several years to 10 years.

So VC is an investment made with 'capital that is fine being tied up for a long time and can endure most of it failing.' It is completely different in the nature of its risk from an individual 'piling everything into a single startup.'