What Is Venture Capital? How Does it Work?

The simple answer to “What is venture capital?” is that it is a type of private equity (PE) funding that is provided to startups and early-stage businesses. Typically, these startups are chosen for their high growth potential, with funding provided by venture capital firms or high-net-worth individual investors who seek equity in return.

We’ve created this article to outline how VC works, who provides it, how to obtain venture capital, and why it plays an important role in global entrepreneurship ecosystems. Importantly, VC is an investment approach that is embraced throughout the world, so we’ve taken a global perspective rather than limiting information to specific jurisdictions.

Understanding the Basics of Venture Capital

Venture capital is a subset of private equity that is entirely focused on engaging with startups or early-stage enterprises. The goal is to provide capital in stages to companies that more traditional lenders would usually consider to be too risky. Indeed, unlike those traditional lenders who would seek repayment and interest, the trade-off in VC is that capital is exchanged for a percentage of ownership equity and influence via board seats. Venture capital investors also tend to focus on innovation-driven industries, such as tech, biotech, life sciences, and clean energy.

What Is a Venture Capital Firm?

A venture capital firm is a registered entity composed of at least one general partner (GP) and multiple limited partners (LP). LPs are passive investors that contribute funds to a pool of capital. While firms may include high-net-worth individuals as LPs, they will often prioritize engagement from institutional investors, pension funds, and family offices that seek high returns. With the funds secured, the GP will develop a portfolio of businesses to invest in, usually, companies aligned with an investment mandate to specialize in certain sectors or growth stages. They’ll also track performance metrics, with returns typically sought after several years via exit events, such as initial public offerings (IPOs) and acquisitions.

What Is a Venture Capital Company?

While the term “venture capital company” can be used interchangeably with “VC firm”, it can also refer to a portfolio company. These are startups or early-stage businesses that have received funding from venture capital firms or individual investors. If a startup is utilizing the label “VC-backed company”, this means that the business has already secured investment from at least one venture capital source. It’s vital to distinguish between the investor, known as a venture capital firm, and the investee—the startup. Each party has a role to play in the venture capital relationship, with the former providing capital and guidance and the latter being responsible for leveraging that backing to drive growth.

How Does Venture Capital Work?

Venture capital investment is typically distributed to portfolio companies across a series of structured stages. Seed funding will be provided for initial development, with Series A, B, and any necessary subsequent rounds provided when startups reach pre-agreed milestones.

The usual process begins with companies giving a venture capital pitch to investors. If a VC firm is interested, they’ll conduct thorough due diligence assessments into the startup’s potential and risks. From here, the parties will negotiate a term sheet that outlines the full investment terms, including valuation and ownership stakes. If agreed, the venture capital firm transfers funds in exchange for equity, and from here the investor will take an active role in guiding the growth of the company.

This all occurs over the course of several years, usually culminating with the VC firm exiting through events, such as IPOs, secondary sales to larger firms, or acquisitions.

Venture Capital vs. Other Types of Funding

Venture capital investment is distinct from other common sources of funding. For instance, angel investors tend to distribute smaller amounts of capital at earlier stages and are often less operationally involved than VC firms. Bank loans have a less dilutive effect on equity, but demand strict repayment terms and collateral demands.  Bootstrapping—self-funding an enterprise—protects startups from equity dilution and gives owners full control, but can be limiting to growth due to resource constraints.

It’s important to recognize that venture capital funding is not suitable for all types of startups. Those not yet ready for rapid expansion are likely to find other funding types more appropriate. Only those with ambitious growth plans and scalable models are likely both to be attractive to VC investors and benefit most from the combination of capital, expertise, and support provided.

Roles in a Venture Capital Deal

There are various key contributors to venture capital deals, these are:

• Founders – Startup founders drive the business’ operations and strategies, alongside aligning their vision with investor expectations.
• Venture capitalists – VCs, which include partners and employee representatives of the firm, drive the investment processes, provide capital, and maintain post-funding oversight.
• Advisors – Experienced venture capital consultants in legal and financial fields assist both parties with regulatory compliance, equity structuring, and other complex elements of the deal.  
• Board members – Following investment, the venture capital firm may appoint new board members. They will usually provide strategic oversight and guidance alongside executing voting rights, which can result in shifts in decision-making dynamics.

Benefits and Drawbacks of Venture Capital

There can be significant benefits to engaging with venture capital funding. Firstly, it can give startups access to large amounts of capital that supports rapid scaling opportunities. VCs can also be good sources of strategic mentorship with experienced business professionals. Not to mention that venture capital backing can lend a startup credibility that provides validation for future investors.

However, the primary drawback to venture capital is that it can dilute equity as founders cede a certain amount of ownership. Founders also face significant pressure to achieve rapid growth which, alongside potential loss of sole control over key decisions, can create tension between startups and investors.

Global Reach and Variations in Venture Capital

While venture capital is present globally, its ecosystems can vary between regions. In the U.S., the model is relatively mature, resulting in a robust infrastructure and a significant number of active firms. The E.U.’s ecosystem is driven by firms fostering innovation from specific regional hubs in Berlin, Paris, and Stockholm, among other spaces. In Asia, government initiatives and domestic markets are supporting an increasing number of venture capital networks.

Alongside differences in activity, each jurisdiction also has regulatory, cultural, and institutional variances. For instance, while U.S. firms often have a more transactional relationship with startups, Asian VCs often prioritize developing long-term relationships. In terms of legislation, too, the U.S. regulatory frameworks are often more streamlined, compared to E.U. countries’ more complex requirements. That said, cross-border investments are becoming more prevalent, with some governments actively backing venture capital funds.

Who Should Consider Venture Capital?

While venture capital can have a positive impact, it’s not the right approach for all businesses. In general, the types of companies most appropriate for VC funding fall into a few key criteria. Firstly, business models that are able to scale rapidly tend to fit the significant growth priorities of venture capital investors. Additionally, having a large addressable market aligns with VC firms’ revenue generation requirements. A strong founding team with experience, drive, and vision also boosts credibility with venture capital investors. 

FAQs

What is venture capital?

It is funding provided to startups and early-stage companies in exchange for equity, usually by specialized firms or wealthy investors.

What is a venture capital firm?

A venture capital firm is an investment organization that manages pooled funds to invest in high-growth startups and guide them toward profitable exits.

What is a venture capital company?

It either refers to the investment firm providing the capital or the startup receiving VC backing, depending on the context.

How do venture capitalists make money?

They earn returns through equity appreciation via IPOs, mergers, or acquisitions of companies they invest in.

Is venture capital suitable for all startups?

No, it is best for startups with scalable models and fast growth potential, often in tech or innovation-driven sectors.

References

Gibson, J. (2025, April 10). Limited Partnership (LP): What It Is, Pros and Cons, How to Form One. iNVESTOPEDIA. https://www.investopedia.com/terms/l/limitedpartnership.asp

Jones, L. (2023, December 1). Everything You Need To Know About Series A, B, C, D and E Funding. Yahoo. https://finance.yahoo.com/news/everything-know-series-b-c-224646859.html?guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referrer_sig=AQAAAExh_GVaei_iMTmfW3wNEvM3s8k54C4-hUhGqneMnnwaV0S1gSQQZwzuAfq6xyll9j4bDzFDAcKWvAHU0JErLO0mFSXxsX3XpVskuiV4DtfuPxdstHSNge1h8gq5OqCRwc3GlVJmtaO5yXgU8rPkBz5IpcoVsh7iGGxFAVZwcfpJ
OECD. (2024, November 24). What is the role of Government Venture Capital for innovation-driven entrepreneurship?. OECD. https://www.oecd.org/en/publications/what-is-the-role-of-government-venture-capital-for-innovation-driven-entrepreneurship_6430069e-en.html