Venture capital is the traditional way of funding early-stage start-ups. Because they are very risky and there is significant asymmetric information about their prospects and profitability, they are usually not suitable as an asset class for retail investors, who may not understand the risks or have the means to acquire sufficient information about their business models and operations. To protect retail investors, there is often regulation that prohibits them from directly investing in start-ups, while crowdfunding in the US is limited to $1 million every 12 months.¹ On the other hand, since a start-up initially requires a small amount of money, it is not worthwhile for large institutional investors to directly invest in them. Venture Capitalists (VCs) fill this gap and guide the company until it fails, it is acquired, or goes public through an IPO.

This funding model has several advantages for start-ups. First, it is usually easier to convince a few VCs to contribute the total capital, rather than persuade many retail investors to contribute small amounts. It is also easier for the founders to keep VCs updated and communicate their vision and plans. As VCs are usually experienced investors and have a long-term horizon, they can provide valuable guidance and steer the project in the right direction. The founders do not need to worry about the daily fluctuations of the share price, as VCs typically lock their funds for 8 – 12 years before they demand a return on their investment.

However, the incentives of the founders and the VCs are not always aligned. For example, it could be that VCs push for an early exit through an acquisition by a bigger firm, rather than support the founders to build a company for the long-term. While they typically have a decade long investment horizon, building strong independent businesses often takes longer. The ever-growing pools of VC money inflate the prices of loss-making start-ups and put pressure on companies to “hyperscale” in order to maximise return potential and stay alive. These “hyperscaled” loss making companies can undercut profit making competitors, leading to “a winner takes all” type of a game and eventually concentrated markets and monopolies. VCs can command high fees by acting as the gatekeepers to capital. Without the finance that VCs provide, it is often impossible to compete against VC backed competitors, who can operate at a large loss. VCs can off-load the shares of these loss-making companies at an IPO or SPAC takeover, with retail investors becoming the ultimate “bag-holders” if the company fails to become profitable and falls in value. Further, the best VC deals are concentrated between the top VCs backed by a small circle of the richest investors, raising potential social inequality questions.

Finally, although VCs act as the gatekeepers of what is funded and what is not, they are not representative of the population. For instance, very few VCs are women. This unavoidably introduces a bias on which ideas get funded, so it is possible that the society misses out on significant projects that could be supported if the pool of potential investors was larger and more diverse.