Venture Capital Explained

Venture capital (VC), the form of private equity involving investment into early stage companies, arose officially in the US in the 1970s when a shift in public policy fuelled it as a legitimate alternative form of small business finance to debt. Since then, VC has expanded exponentially.

Today it is one of the most popular asset classes globally, and attracted a record $671 billion across 38,644 deals in 2021 (almost double the $347 billion the year prior).

Global Venture Capital Activity

VC has a history of helping to build world-leading companies. Currently, eight of the ten biggest firms in the world by market capitalisation were built with the help of VC, including Apple, Microsoft and Amazon. 

- Forbes

Exploring the advantages associated with venture capital can help investors to understand how the asset class is able contribute to their portfolio. Where opportunities can differ considerably from case-to-case, a number of core benefits are typically associated with VC.

Considerable Returns
Due to venture capital investments being made into companies at an early stage of maturity, this allows opportunities the potential to deliver considerable investment growth when compared with more mature private equity and listed equity options. Individual VC investments generally target between 5x-20x money-on-money returns, though some opportunities can target considerably higher.

Risk-Mitigating Tax Reliefs
In the UK, investors can make use of schemes such as the EIS and SEIS when investing in early stage companies to benefit from an additional range of tax incentives. Ranging from 30% income tax relief to capital gains tax exemption and inheritance tax exemption, these reliefs combine to help investors minimise the risk and maximise the potential returns associated with early stage investments.

The below table illustrates three potential outcomes of a £50,000 EIS-eligible investment for an additional rate taxpayer, in which the hypothetical company fails, breaks even and triples in value. 

Portfolio Diversification
With early stage companies existing across a broad range of sectors and geographies, and each opportunity possessing its own level of target growth and exit plan, naturally, venture capital lends itself as a powerful portfolio diversifier for investors looking to achieve a  calculated spread of risk across all of the above.

Alternative Investment Benefits
Categorised as an alternative investment (not falling under the traditional investment umbrella of listed equities, bonds and cash), venture capital is associated with the range of advantages typically linked to alternative assets. These include reduced correlation to market fluctuations and lower volatility to external fiscal events such as rapid inflation.

Positive Impact
Venture capital can provide individuals with the opportunity to invest in some of the world's most impact-driven startups and scaleups. Whether it is by backing the next energy-efficient housebuilder, medical manufacturer or SME lending platform, investors can balance generous target returns with positive environmental, social and governmental (ESG) impact within their portfolio.

Whilst posing a number of attractive investor benefits, venture capital is classified as a high-risk/high-return investment method. Subsequently, investors should weigh up the potential disadvantages associated with the asset class before investing.

Risk to Capital
VC investments are typically made into small, early stage, unquoted businesses, and whilst this can provide them with considerable growth potential, it can also make them more prone to failure. To minimise the chance of capital losses, investors can conduct thorough due diligence into providers, ensure their portfolio is adequately diversified and make use of tax efficient investment schemes. 

Lower Liquidity
Unlike traditional, listed equities that are able to be traded instantly on the stock market, venture capital is less liquid. This is partly due to VC schemes (such as the EIS, SEIS and VCTs) requiring minimum holding periods before tax relief can be claimed, but is ultimately due to early stage companies generally taking several years before they are able to reach an attractive exit event.

Where venture capital was once reserved strictly for institutional investors, today VC is one of the most popular asset classes among investors globally. Though various investor types can now access VC in some capacity, the asset class can be particularly attractive to three groups in particular. 

Experienced Private Investors
With venture capital classified as a high-risk/high-return investment strategy, an adequate level of prior investment experience can be highly beneficial when selecting the most appropriate opportunity. Not only is an experienced investor is more likely to ensure the benefits of any relevant VC schemes are utilised, but that their portfolio is adequately diversified to maximise the impact of their investments.

High-Net-Worth Private Investors
With most high-net-worth investors (HNWI) accruing substantial annual tax liabilities, venture capital schemes such as the SEIS - that offer advantages including 50% income tax relief - can prove especially valuable. The comparably high money-on-money returns private equity often targets can also prove attractive for individuals with a higher level of disposable income (reflected in the figure below).

Institutional Investors
Institutional investors tend to allocate a significantly greater proportion of their portfolios to VC than retail investors, with the average institutional investor allocating 25% of their portfolio to private equity (VC's parent asset class). This is largely due to VC's ability to deliver superior long term returns - with institutional investors generally possessing a longer term vision and a higher tolerance for liquidity.

Private Equity Allocation Across Investor Type

Venture capital opportunities can be accessed by investors via several routes, but most commonly fall under one of three categories.

Direct Investment
Direct venture capital investments occur when investors invest in an early stage company without the involvement of any intermediary. Whilst this offers the investor full autonomy over selection, it can carry higher risks due to a lack of participation from any other professional institution. For this reason, this route is most often followed by especially experienced with a strong background in a given sector.

Co-investment Platforms
Co-investment platforms compile a range of opportunities for investors to select from at their will, with reputable platforms researching, vetting and advertising companies to ensure they hit a strict eligibility criteria. Still offering full investor autonomy, co-investment platforms can mitigate some of the risk associated with investing in venture capital due to the input of a professional organisation.

Funds
Venture capital funds (commonly recognised in the form of venture capital trusts [VCTs]) pool investor capital to invest in a portfolio of companies. These companies are determined by a fund manager, who will usually charge additional fund fees. Though offering more effortless diversification, funds usually target less considerable growth than individual opportunities and allow less investor autonomy.