Venture capital and investment banking can be hard to tell apart for many outside of the financial industry. While these two types of financial firms are similar, they are also quite different. Here's a quick breakdown of the differences you need to know.
First, what is venture capital?
Venture capital is a type of investment capital where the venture capital firm invests in a new or fast growing business or start-up that have the potential for significant returns, but also a high risk of loss.
Small start-ups are not large enough to access the global capital markets available to large, established corporations. Many of these start-ups still need sizable amounts of capital to scale their businesses into meaningful entities. Venture capital firms fill in this gap between proven idea and scale by investing in these companies, typically by taking equity stakes.
Venture capitalists, those investors and firms that provide venture capital, make many different, relatively small investments with the hope that a few will have outsized success. The venture capitalists accept that some of their investments will fail and lose their capital, however, the select few homeruns should offset those losses with enough left over for significant profits.
Because venture capital firms take equity stakes when they invest in a company, venture capitalists will often take board seats at the company and exert significant influence on how the business operates.
So what is investment banking, then?
An investment bank is a general term to describe banks that assist companies in raising investment capital. These banks are generally intermediaries, but can also be direct investors. At their core, they help individuals or businesses raise capital.
For example, when a company wants to join the public markets via an initial public offering, the company will hire an investment bank to help them handle regulatory issues, find investors, and successfully execute the IPO.
Or, if a company wishes to acquire or be acquired by another company in a merger or acquisition, investment banks will act as the brokers in the transaction, assisting the buying and selling company. Investment banks have also helped their clients with raising debt from both the bond market as well as from banks or other lenders. Other times still the investment bank may simply act as a consultant, providing advice to a company on financial matters or possible M&A opportunities.
Investment banks primarily earn their profits by charging their clients fees to assist them in whatever role the bank takes on. This could be advisory fees for advice, broker fees for assisting in a merger or acquisition, or any number of other fee structures. Some investment banks also have in house trading businesses, where the bank trades securities to create even more profits.
Boiling down to the key differences
The first and primary difference between venture capital and investment banking is that venture capital firms typically invest directly into companies, while investment banks tend to serve as intermediaries in various financial transactions. As such, they also earn their profits in different ways. Venture capitalists rely on the returns from their investments, and investment banks are more likely to charge fees for their services.
Venture capitalists and investment banks also target different prospective customers. Venture capital firms tend to stick to high potential start-ups with big upside. Investment banks are more likely to work with established firms that already have the size necessary to access the broader capital markets in the U.S. and globally.
At the end of the day, both venture capital firms and investment banks have important roles to play in the financial system. Both help firms get access to the capital and resources they need to grow and flourish. Venture capital firms do it with equity investments in start-ups that have big risks but big potential rewards. Investment banks do it by helping companies manage the complex world of mergers and acquisitions, capital markets, and financial intermediation.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.