TL;DR. Venture capital is a high-risk equity bet on early-stage companies that can’t borrow yet and are too small to go public. VCs raise ten-year funds from institutions, write equity cheques in staged rounds (seed → Series A/B/C → growth), and try to return the fund through a handful of outlier exits. The deal terms — preferred stock, board seats, liquidation preferences, anti-dilution — live in a document called the term sheet, and when a startup raises at a lower price than last round (a “down round”), those terms decide who absorbs the loss.
What is venture capital?
Venture capital is a form of private equity that funds young, fast-growing companies in exchange for an ownership stake. The pitch to investors (limited partners, or “LPs”) is that most VC bets fail, a few break even, and one or two return many times the fund — enough to drag the whole portfolio to a premium return. LPs are usually pension funds, endowments, sovereign wealth funds, family offices, and corporate balance sheets. The fund itself is run by a small team of general partners (GPs).
The standard fund structure is a closed-end limited partnership with a roughly 10-year life: an investment period of 3–5 years to deploy capital into new companies, followed by 5–7 years of “harvesting” — supporting portfolio companies through follow-on rounds and steering them toward an exit. GPs earn a management fee — typically around 2% of committed capital per year — and a share of the profits called carried interest, typically 20% above a return hurdle (background). That “2 and 20” model is the same fee structure used by most hedge funds and private-equity buyout funds.
Because the securities sold to LPs aren’t registered with the SEC, VC funds rely on private-offering exemptions, mainly Rule 506(b) and 506(c) of Regulation D. Investors in the fund (and in the startups themselves) generally have to qualify as accredited investors — broadly, individuals with net worth over $1 million (excluding primary residence) or income over $200,000 ($300,000 with a spouse) in each of the last two years, per the SEC’s Investor.gov bulletin.
The funding stages: from idea to IPO
A startup that goes the distance usually raises through a sequence of named rounds. Each round prices the company higher than the last (in good times), sells a slice of new equity to incoming investors, and dilutes everyone who held shares before. The names are conventions, not legal categories — but the conventions are stable enough to plan against.
| Stage | Typical round size | Typical post-money | Equity sold | What the money usually buys |
|---|---|---|---|---|
| Pre-seed | $0.25M–$2M | $3M–$10M | ~10%–20% | Idea, first hire, prototype |
| Seed | $2M–$5M | $10M–$25M | ~15%–25% | Early product, first revenue |
| Series A | $8M–$20M | $30M–$80M | ~15%–25% | Product–market fit, scale GTM |
| Series B | $20M–$60M | $80M–$250M | ~15%–25% | Scale operations, international |
| Series C+ | $50M–$200M+ | $250M–$1B+ | ~10%–20% | Category leadership, M&A |
| Growth / pre-IPO | $100M–$1B+ | $1B–$50B+ | ~5%–15% | Secondary liquidity, IPO prep |
Not every company raises every round. Many bootstrap to Series A and skip seed; others raise multiple seed extensions and never get to A. And a growing share of the largest financings — what Carta and others call “growth-stage” rounds — now happen entirely in the private market, which is why companies stay private longer than they used to.
What’s in a term sheet
A term sheet is a short, mostly non-binding document that spells out the price and the rules of a financing before lawyers draft the definitive agreements. The NVCA model legal documents — published by the National Venture Capital Association and revised annually by its General Counsel Advisory Board — are the de-facto industry template; most US VC rounds use a close variant. The NVCA describes them as the “industry-embraced model documents” that aim to “avoid bias toward the VC or the company/entrepreneur.”
Six provisions do most of the economic work:
- Pre-money valuation and round size. Pre-money + new money = post-money. New investor ownership = new money / post-money.
- Preferred stock. VC investors buy a class of preferred shares that sits ahead of common stock (held by founders and employees) in a liquidation.
- Liquidation preference. Usually “1x non-participating”: in a sale, preferred holders can take back their original investment first, or convert to common and share pro-rata — whichever pays more.
- Anti-dilution protection. If a later round prices below this one, the preferred conversion ratio adjusts so the earlier investor isn’t diluted as aggressively. The market standard is “broad-based weighted average.”
- Option pool. A pool of common shares reserved for future employees, almost always created (or topped up) inside the pre-money — meaning founders, not new investors, bear the dilution.
- Board, protective provisions, pro-rata rights. One or more board seats, a veto list (issuing new senior stock, changing the cap table, selling the company), and the right to buy enough of future rounds to maintain ownership.
A worked example: the dilution math behind a Series A
Suppose two founders own 5,000,000 shares of common stock each — 10,000,000 shares total. A VC offers a $10M Series A at a $40M pre-money valuation, with a 10% post-money option pool. The math reorders the cap table like this:
- Post-money valuation = $40M + $10M = $50M.
- New investor share = $10M / $50M = 20%.
- The 10% option pool is created from the pre-money, so founders absorb that dilution before the VC’s cheque is counted.
- Founders’ combined share falls from 100% to roughly 70% (90% × 78%, rounded): the 10% option pool first, then 20% to the new investor.
Two things stand out. First, the option pool quietly costs founders roughly 10 percentage points before the VC’s name appears on the cap table — a frequent point of negotiation. Second, by the time a successful company reaches an IPO after Series C or D, founders commonly hold 15%–25% of the company; the rest belongs to investors, employees, and (post-IPO) the public.
Down rounds: when valuations reset
A down round is a financing priced below the previous round’s per-share price. Down rounds happen when markets cool, growth slows, or a previous round was simply overpriced. They are common enough to be a standard scenario the term sheet accounts for in advance.
Two mechanisms do most of the work:
- Anti-dilution adjustment. With the market-standard broad-based weighted-average formula, the prior investor’s preferred shares convert into more common shares — partially making them whole. Full-ratchet anti-dilution (the more aggressive variant) resets their effective price to the new, lower price. Founders and employees, holding common stock, get no such adjustment.
- “Pay-to-play” provisions. Sometimes existing investors must participate in the down round (write more cheques) or lose their preferred protections, converting to common. This is how messy recapitalisations are forced when a company needs cash and old investors don’t want to lead.
The headline number to watch in industry reports is the share of US financings that price flat or down. Carta and the PitchBook-NVCA Venture Monitor both track this — it ran in single digits at the 2021 peak and rose into the high teens during the 2022–2024 reset, especially at Series B and Series C. It’s a useful proxy for the health of the late-stage market.
Common mistakes (and what beginners miss)
- Confusing pre-money with post-money. A “$40M valuation” with a $10M raise puts the post-money at $50M and the founders’ stake at 80%, not 100%.
- Ignoring the option pool gotcha. Option pool “shuffle” — funding the pool from the pre-money — quietly costs founders several percentage points.
- Treating liquidation preferences as cosmetic. A 1x non-participating pref is mild; a 2x participating pref means investors get their money back twice and then share in the rest. In a soft exit, the difference can leave common holders with nothing.
- Assuming valuation = wealth. Until there’s a liquidity event, on-paper valuations are just the price of the most recent share, multiplied across the cap table. Secondary markets and tenders are the only way to monetise early.
- Mistaking growth-stage rounds for IPOs. A $200M Series D at a $5B valuation is still a private placement under Reg D. There’s no public float, no daily mark, and the company can — and often does — see its valuation reset before or at IPO.
What to learn next
If this helped, the natural follow-ons are: the difference between direct listings, traditional IPOs, and SPACs; how IPO lock-up periods shape post-listing supply; and how the leveraged buyout world relates to VC at the late-stage boundary.
Sources
- NVCA Model Legal Documents — industry-standard term sheet, stock purchase agreement, voting agreement, IRA, ROFR, and related VC financing templates.
- SEC Investor.gov bulletin: Accredited Investor — net worth and income thresholds.
- SEC Rule 506 of Regulation D — private offering exemption commonly used by VC funds and their portfolio companies.
- PitchBook-NVCA Venture Monitor — quarterly US VC deal volume, round sizes, and down-round share.
- Carta State of Private Markets — median round sizes, valuations, and dilution by stage.
- Venture capital — reference overview — fund structure, 2/20 fee model, and stage definitions.
Disclosure: This article was produced with AI assistance and reviewed before publication. It is for informational purposes only and is not investment advice.