Venture capital has provided the investment to turn digital pipe dreams into multi-billion dollar companies since the end of World War Two.

The Financial Times Lexicon defines venture capital as:

Image: iStock/cigdemhizal
Image: iStock/cigdemhizal

"Private equity or institutional funding for start-up companies considered to have strong growth prospects. There can be several phases of investment (see seed money), through to the stage when the company is able to go public. Venture capital firms may also provide management assistance and other services.

Typically, the companies that venture capital firms invest in have a high risk of failure but the potential for a high rate of returns. These returns will depend on how much the company grows following the investment.

As venture capitalists have a stake in the company, they will also generally want a say in business decisions.

How does venture capital work?

The money in venture capital funds comes from a variety of sources. They include pension funds, corporations and wealthy individuals. The venture capital firms then manage this investment for their clients and try to ensure the company they're funding is a success.

Venture capital (VC) firms typically make their first investment in a Series A round, although some will invest earlier in what is called a seed round. Some firms specialise in late stage funding though.

Startups looking for venture capital will generally send their business proposals to the VC firms they want to be involved in their business and pitch their idea to them in the hope of securing investment.

Any interested firms will then conduct due diligence on the founders and the business to assess the risk. They will then pledge an investment in the company in exchange for equity.

Read next: Here are the 22 UK venture capital firms that startups should know about

This equity also gives them influence over the direction of the business. They will normally have a member of the firm sitting on the board and will often have voting rights and blocking rights over key decisions.

The funding is often provided in stages as the startup reaches specific milestones. VC firms typically look for a return of at least 20 percent per year over the lifetime of the investment.

The investors in the fund also make an annual payment to the fund manager, generally of 2-3 percent of the committed capital.

Their investment will typically last for between four and eight years and end when investors 'exit', through a merger, acquisition, or an Initial Public Offering (IPO). The venture capital firm will then sell their shares and hope to make a major profit.

Mixed results of venture capital

Google's experience with venture capital shows how all parties can benefit from the investment.

In 1998, Google founders Larry Page and Sergey Brin sought investment from two of Silicon Valley's biggest venture capital firms: Sequoia Capital and Kleiner Perkins Caufield & Byers. Page and Brin already had the contacts, pedigree, ambition and a working beta site.

The firms invested a combined $25 million in the company for an estimated 40 percent stake. They let the Google founders retain majority control, but insisted Google add an experienced executive to their team to help them run the business.

In 2001, Google made Eric Schmidt the company's first CEO. He added conventional business expertise and experience to Page and Brin's technical knowledge and ambitious ideas. The arrangement helped everyone involved make billions of dollars.

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Not every venture capital story has such a happy ending.

Beepi founders Ale Resnik and Owen Savir had high hopes that their startup would make them both a fortune. The company would inspect second-hand cars and use an algorithm to connect the seller to buyers. Beepi would take a commission on the sales of each vehicle.

The concept convinced venture capital firms to invest a total of almost $150 million by late 2015. But just one year later, the company was bust and the investment gone.

Part of the reason the startup failed was that it had raised more money than it was worth. The result was a company with an inflated valuation that didn't match its revenue, and had become an overpriced acquisition that couldn't attract a buyer.

Should you seek venture capital?

Venture capital provides financing for companies that lack the cash flow, collateral or profile necessary for business loans, but few of them will attract the interest of major VC firms.

Those that do will have a combination of a unique idea, a scalable business proposition, a clear market opportunity, a strong team, and a convincing plan of how to acquire customers. It will also need to be for a sector that the firm wants to invest in.

Even if the business can attract venture capital funding, it might not be the right type of investment for the company.

The addition of a VC fund's input on decisions can be both a strength and weakness. It will impose some limits on your independence but add a level of strategic expertise and business experience that startups often lack.

Other financing options might be a better choice. Angel investors are more appropriate for a smaller business looking for a limited amount of backing and the freedom to manage the business without interference from the investor.

Read next: How to run a successful crowdfunding campaign

Many businesses rely on self-funding, support from family and friends and a line of credit to get them through their early days. This model of funding a company without external help or capital is known as 'bootstrapping'.

Crowdfunding and loans from banks, government organisations and non-profits are other ways to get a welcome cash injection.

Venture capital firms can help make startup founders rich but they can also break them. Ousted Uber boss Travis Kalanick is finding out just how much damaging they can be. 

The former CEO is being sued for fraud, breach of contract and breach of fiduciary duty by Benchmark Capital, one of Uber's early backers.  

Benchmark has already helped drive the charge that forced Kalanick to resign as CEO. If their lawsuit is successful they could end his prospects of making a return.

Sympathy for Kalanick is in short supply after a string of scandals at Uber under his watch, but his experience shows that the dream of raising venture capital can end up as a nightmare.