How Venture Capital Works
One of the most important things founders should understand when building a startup is how venture capital works. It's a form of private equity used to back startups and early-stage companies with impressive growth potential.
Venture capital plays a central role in the startup ecosystem. It provides the funding that allows companies to invest in product development, hiring and growth before they become profitable. Venture capital funding is crucial for startups that may not have access to traditional sources of capital, such as bank loans.
But venture capital is not simply about raising money. Venture capitalists are willing to take on high risk compared to private equity firms, which typically invest in more mature companies with more predictable outcomes.
It comes with expectations around growth, returns and timelines that shape how a company operates.
Understanding how venture capital works helps founders make better decisions about when to raise capital, how much to raise and whether it is the right path for their business. Venture capital plays a critical role in the innovation economy by driving economic growth and supporting high-growth startups.
How Venture Capital Works
What Venture Capital Is
Venture capital (VC) is a form of investment where funds invest in early-stage or high-growth companies in exchange for equity. In this arrangement, venture capitalists receive an equity stake or ownership stake in the startup, becoming shareholders with an interest in the company's success.
Unlike traditional financing, venture capital does not require repayment. Instead, investors generate returns by owning a portion of the company and benefiting from its growth in value over time.
Venture capital firms typically invest in companies that have the potential to scale rapidly and achieve large outcomes. A well-developed business plan is essential for attracting venture capital and facilitating due diligence during the investment process, that will include looking at a broader set of SaaS metrics to evaluate performance.
Because of this, VC is most commonly associated with technology startups, particularly those building software or platform-based businesses. Creating a pitch deck is one of the first steps in preparing for venture capital funding.
How Venture Capital Funds Work
Venture capital firms manage funds that are made up of capital from external investors.
These investors are known as Limited Partners (LPs) and can include:
pension funds
family offices
high-net-worth individuals
institutional investors
VC firms raise money from limited partners to invest in multiple companies, often targeting 25-30 investments per fund to diversify risk and maximise potential returns.
The venture capital firm acts as the General Partner (GP), responsible for deploying that capital into startups.
A typical venture fund operates over a 10-year lifecycle:
the first few years are spent investing in companies
the remaining years are focused on supporting those companies and generating returns
The goal of the fund is to return capital to LPs at a multiple of what was originally invested.
Why Venture Capital Exists
Venture capital exists because startups are inherently risky.
Venture capital investments are generally illiquid, meaning they cannot be quickly converted into cash.
Many early-stage companies fail or never reach significant scale.
The majority of startups fail, so investors risk losing their entire investment.
To compensate for this risk, venture capital relies on a small number of highly successful companies to generate the majority of returns.
These are often referred to as outlier outcomes.
A single successful investment can return the entire fund and more, which is why venture capital firms look for companies with the potential to become very large.
The venture capital environment is volatile, with only a small percentage of startups actually making it to an exit event.
How Venture Capital Firms Make Decisions
When evaluating startups, venture capital firms are not just assessing the current state of the business. The due diligence process is a critical step, involving a thorough evaluation of the startup's business model, market opportunity, team, and financials.
They are trying to understand:
the size of the market opportunity
the strength of the founding team
the scalability of the business model
the potential for long-term growth
VCs use their investment strategy, industry expertise, and managerial expertise to identify startups with high growth potential. They often identify startups through networking, referrals, and startup events, and typically require a pitch deck for evaluation.
Many leading venture firms, such as Sequoia Capital and Y Combinator, focus on identifying companies with the potential to achieve outsized outcomes. Because venture capital relies on outsized outcomes, firms often prioritise potential over current performance.
This is why early-stage startups can raise capital even when they are not yet profitable. Venture-backed companies often manage burn rate and runway carefully to ensure startups reach key milestones.
Venture Capital Funding Stages
Startups typically raise capital through a series of funding rounds as they progress through the early stages of growth. These funding rounds—such as pre-seed, seed, Series A, Series B, and later rounds—are designed to provide the necessary resources at each phase of a startup's development.
Early stage funding includes the pre-seed and seed rounds, which are critical for product development, market research, and validating market fit before scaling further.
VC funding is typically provided in multiple rounds over several years, depending on the startup's growth trajectory and evolving needs.
Pre-seed and Seed
These are the earliest stages of funding.
Capital is often used to:
build the initial product
validate the market
achieve early traction
Series A
At this stage, companies are typically focused on:
scaling the product
improving customer acquisition
building repeatable growth channels
Series B and Beyond
Later-stage funding is used to:
scale operations
expand into new markets
strengthen market position
Late-stage investing typically occurs in Series B, C, or later rounds and often involves hedge funds, larger venture funds, and investments in more mature companies that have already demonstrated significant growth and revenue.
As companies progress through these stages, both the size of the investment and the expectations around growth increase.
What Venture Capital Investors Expect
Venture capital investors are typically looking for:
High growth
Startups are expected to grow quickly, often prioritising growth over short-term profitability.
Large market opportunity
Companies should be operating in markets with the potential to support significant scale.
Strong unit economics over time
While early-stage companies may not be profitable, there should be a clear path toward sustainable economics. VCs will look closely at metrics such as CAC and LTV to understand the efficiency of growth.
Clear exit potential
Investors need a way to realise returns, usually through an acquisition or public listing.
An initial public offering (IPO) is a key exit strategy for venture capitalists, allowing them to achieve a liquidity event and realise returns on their investment. Typically, VCs aim for such liquidity events—either through an IPO or acquisition—within a 5–10 year horizon.
How Venture Capital Impacts Founders
Raising venture capital can significantly influence how a company is run.
Startup founders should understand how venture capital can shape company development, including the need to align their vision and business model with investor expectations and strategic growth priorities.
With external capital comes:
increased expectations around growth
accountability to investors
pressure to achieve specific milestones
For some companies, this can accelerate growth and unlock opportunities that would not otherwise be possible.
For others, it can create pressure that may not align with the long-term vision of the business.
Understanding the investment process and the expectations of venture capitalists is essential for startup founders seeking funding.
Lessons from Scaling a Venture-Backed Company
During my time helping scale Canva from roughly US$10 million in revenue to more than US$2 billion, venture capital played an important role in supporting the company’s growth.
Access to capital allowed the business to invest in product development, infrastructure and global expansion at a pace that would not have been possible otherwise. Venture capitalists not only provided financial support but also contributed expertise, mentorship, and access to business networks to help drive the company's growth and success.
At the same time, maintaining discipline around financial metrics and long-term strategy remained critical.
Venture capital can accelerate growth, but it does not replace the need for strong fundamentals.
Common Mistakes Founders Make
Venture capital is often misunderstood, particularly by first-time founders.
Understanding the ownership structure of your company, including how capitalisation tables work, is crucial when raising venture capital. This transparency helps manage equity percentages among investors, founders, and stakeholders.
Some common mistakes include:
Raising without a clear plan - capital should be tied to specific milestones and outcomes.
Not understanding the time and effort required to raise capital.
Focusing too much on valuation and not enough on the terms of the deal.
Failing to build relationships with investors before fundraising.
Assuming VC is the only path - Not all businesses need venture capital. Some may be better suited to bootstrapping or alternative funding models.
Founders should prioritise the most important terms during negotiations to avoid appearing inexperienced, and establish clear communication channels and well-defined expectations to help mitigate governance challenges in venture capital investments.
Frequently Asked Questions
Do all startups need venture capital?
No. Venture capital is best suited to companies with the potential to scale rapidly in large markets.
VC funding primarily targets emerging companies and promising startups—early-stage businesses with high growth potential that are positioned for significant expansion and eventual exit opportunities.
How do venture capital firms make money?
By investing in companies and generating returns when those companies increase in value and eventually exit. The goal of venture capital firms is to generate significant returns on their investment through the eventual sale or public offering of the company's shares, such as acquisitions or IPOs. The success of a venture capitalist's portfolio determines their ability to raise additional funds from limited partners.
What is dilution?
Dilution refers to the reduction in a founder’s ownership percentage as new investors receive equity in the company.
Final Thoughts
Venture capital is a powerful tool for scaling startups, but it is not the right path for every company.
Understanding how venture capital works allows founders to make more informed decisions about funding, growth and long-term strategy.
For those building high-growth technology companies, venture capital can provide the resources needed to scale quickly and capture large market opportunities.
But it also comes with expectations that shape how the business operates.
Being clear on those trade-offs is essential before raising capital.
Author
Damien Singh is the former CFO of Canva, where he helped scale the company from approximately US$10 million to more than US$2 billion in revenue.