Everything you need to know about Venture Capital

Venture capital is probably one of the most commonly used terms in the startup world, and venture capitalists (VCs) are one of the most important stakeholder groups for startups. 

Despite being a huge part of this ecosystem worldwide, the basics of venture capital and its background are unknown to many. In this article, we introduce the ABCs of venture capital and explain how it actually works. 

How venture capital emerged and became established

The roots of modern venture capital lie in the United States. Before World War II, most early investments came from wealthy families, but after 1945 the industry began to take a more institutional form. Companies such as American Research and Development Corporation (ARDC) and J.H. Whitney & Company played a pioneering role. A major milestone was the Small Business Investment Act of 1958, which allowed the creation of licensed investment companies and encouraged market participation. Later on venture capital became increasingly associated with new technologies, supported by the breakthrough successes such as Apple and Genentech in the 1970s and 1980s helped establish VC as a central driver of innovation. 

Germany entered the venture capital landscape later, beginning in 1975 with the founding of the Deutsche Wagnisfinanzierungs-Gesellschaft (WFG).  

How venture capital works

Venture capitalists invest in early companies that have the potential to grow significantly. VC firms raise capital from institutional investors such as pension funds or foundations and bundle it into a fund. This fund is then invested in promising startups over several years.

The investment process typically begins with the startup developing a strong business plan that shows the market opportunity, the business model, the financial needs, and the long-term strategy. Once founders identify relevant VC firms, they present their idea in an initial pitch designed to spark interest. If investors see potential, they begin a thorough due-diligence process. This involves examining the startup’s finances, team, market, technology, legal structure, and risks. Due diligence often lasts several weeks or even months and forms the basis for the final decision.

If the investors decide to proceed, both parties negotiate the terms of the investment. This includes the amount of capital, the percentage of equity the VC receives, governance and voting rights, and the expected exit strategy. After the agreement is signed, the capital is released. Venture capitalists frequently take an active role in the company, offering strategic guidance, access to their networks and support in company operations.

The ultimate goal of a VC investment is the exit - the moment when the investors sell their shares and realize returns. This can occur through a sale to a larger corporation, a secondary sale to other investors, or an initial public offering (IPO). Because VC investments are risky, the expectation is that only a small number of portfolio companies will generate outsized returns that compensate for the majority that will remain modest or fail.

What founders should pay Attention to

Venture capital can speed up growth a lot, but there are also important implications to consider. As VC funding involves equity financing, founders must give up part of their ownership and accept that investors will have a say in major decisions. Therefore, a VC partnership requires trust, transparency and a shared long-term vision.

Startups must also be prepared for the high expectations associated with VC financing. Investors typically look for growth and scalability. Companies that prefer slow, steady expansion or operate in markets with limited potential may find that VC pressure does not align with their business vision. 

Which startups is venture capital suitable for?

Venture capital is most suitable for startups that operate in dynamic, fast-growing markets and have a business model that can scale quickly. Such companies often require significant upfront investment and therefore benefit from the financial strength and expertise that VC investors bring. Startups that thrive under VC financing typically have a strong founding team, a clear market need, a defensible product or technology, and the ambition to become a leading player in their sector. 

VC funds typically invest from the startup phase, i.e. the market entry phase, which is when the product or service is ready for market but lacks the necessary capital and resources for successful market entry. Many traditional VC funds get involved at this point to support scaling up.