Economics Explained: What is Venture Capital?

What is venture capital?

Venture capital refers to private financing that services early-stage and high-growth companies. Venture capitalists (VCs) typically provide financial capital in exchange for an ownership stake in the company (equity) and may take an active role in guiding the company’s growth, development and maturity.

Venture capital is crucial to the innovation ecosystem, as venture capitalists typically provide a specialist source of funding for companies that may not otherwise be able to secure funding due to not yet having proven track records or sufficient collateral to secure loans. These characteristics make them less desirable to risk-averse lenders like banks. VCs nonetheless conduct thorough due diligence in portfolio companies, typically searching out investment-ready enterprises that showcase innovative ideas, strong management teams, and the potential for high returns.

The benefits to the investors include the opportunity to earn significant returns far beyond the market indices. Although not all investments yield high returns, a well-managed portfolio makes it an attractive asset class for investors seeking high-risk, high-reward opportunities.

Considerations when raising venture capital

For enterprises, pursuing venture capital is not without its drawbacks. Although VCs play a vital role in the development of many successful Vancouver businesses, not all entrepreneurs seek it out for a myriad of reasons:

Difference between angel investors and venture capitalists

Angel investors are high net worth individuals who invest their own money into startups in exchange for an equity stake, often for reasons more than just financial returns; for example, they might want to support business owners from underrepresented or equity-seeking communities, or they feel passionate about a product or service developed by a company.

For this reason, angel investors often invest in very early-stage companies, and their investments are typically smaller than those made by venture capitalists (in the range of $25,000–$100,000, as opposed to $3 million–$5 million). However, angel investors who are experts in the startup’s field may be more enthusiastic and more open to being engaged by founders in the fund-raising process.

Venture capitalists raise money from groups of investors into a combined fund to invest in early-stage or emerging businesses. Due to differences in the nature of the money being invested (personal vs. group), there may be a different tolerance for risk: angels investing their own money may be more risk averse, while funds comprised of investor group money might take on greater levels of risk.

Venture capitalists also tend to invest a little later in the startup lifecycle than angel investors do, usually coming into the picture when companies have already shown traction and have a proven business model. As VC’s usually invest larger sums of money, they are more likely to take a more active role in managing the companies they invest in, often sitting on the company’s board of directors or providing additional mentorship and guidance.

Venture capital and diversity

One of the main criticisms of venture capital is the uneven distribution of investments across demographic groups: various studies suggest that less than three percent of total venture capital investment went to female-founded businesses in 2019 and 2020, and an even smaller amount to businesses founded by Indigenous, Black or People of Colour (IBPOC). Some argue that one of the reasons for this is a lack of understanding or awareness due to unconscious bias, possibly attributable to lack of diversity in the venture capital firms themselves (see the below breakdown of US venture capitalists).

In Canada, however, associates in venture capital firms have slowly begun to diversify, although a report commissioned by the Canadian Venture Capital and Private Equity Association and BDC Capital found there remains a significant gap in IBPOC and women partners at private equity and venture capital firms, and reports challenges on retaining these hires.

Vancouver-based organizations like Future Capital, Raven Indigenous Capital Partners and WEL Vancouver are working to move the dial by providing education in startup investing, networking opportunities and communities for investors, as well as to catalyze wealth generation in equity-seeking communities.

This transformation cannot come too soon: the Globe & Mail reports fears by the startup community that an economic downturn would have greater impacts on women-founded startups, and IBPOC businesses are likewise harder hit during these times.

“Venture capital is a historically difficult industry to break into. The lack of diversity that exists within the ecosystem creates an even higher barrier for minorities and individuals with non-traditional backgrounds. This is why the most important thing we can do for our network is to create the conditions for them to gain meaningful experiences, drive relevant opportunities and develop their own strategy for startup investing.”

Marlon Thompson, Founder and CEO, Future Capital

Cross-border capital

A significant source of venture capital for Vancouver businesses comes from the US. Research conducted by VEC suggests many US investors struggled to understand the advantages, as well as the legal and financial considerations, of investing in Vancouver businesses. VEC developed the Vancouver Cross Border Investment Guide as a resource to support US investors in navigating these systems when investing in Vancouver.

The Vancouver Economy Report

A version of this article was published in our venture capital feature in the Summer 2023 Vancouver Economy Report. For more stories on Vancouver’s economy and on venture capital in Vancouver, be sure to check out that issue, and subscribe today.
 
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