How does a Venture Capital firm work?

Category: Understanding startup investment

There’s more money than ever in the startup funding market across all funding stages. In previous articles we discussed the financing options available to startups and also the criteria used by investors when deciding which startups to back. Now it’s time to get a little bit closer to the elephant in the room: Venture Capital firms.

As we’ve previously mentioned, Venture Capital is a form of a financing that’s self-explained: it consists of funds or firms that provide ‘venture capital’, meaning high risk capital that supports companies and organizations with the hope that these provide a great return on investment (ROI).

There are many terms associated to the Venture Capital industry that might not be known to other investors and entrepreneurs, and in this article we’ll try to explain the main ones.

 

How does a Venture Capital firm work?

There are two key elements within a VC fund: general and limited partners. The general partners are the people in charge of making investment decisions (finding and agreeing to terms with startups and companies) and working with startups to grow and meet their goals. On the other hand there are limited partners, the people and organizations who provide the capital necessary to complete those investments.

In other words, general partners make the investments and limited partners provide the funds.

This is one of the key differences between VC funds and other investment vehicles: Venture Capital funds don’t invest the money of their own partners, but that of limited partners such as pension funds, public venture funds, endowments, hedge funds, etc. General partners might invest some of their own money through the fund, but this tends to account for only 1% of the size of the fund.

Does this mean that VC firms also need to ‘fundraise’?

Yup, that’s exactly right. Startups need to fundraise to convince Venture Capital firms, business angels, etc to give them money in exchange for equity. The case for VC firms is similar. General partners must convince some of the organizations aforementioned to invest in the fund with the promise of big returns (between 5X and 10X) in a certain period of time (usually 10 years).

The VC firms must then go on to make clever investments so they can give the limited partners their money back… plus a profit.

How do Venture Capital firms make money?

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The way Venture Capital funds make money are two fold: via management fees and carries (carried interest).

  • Management fees: management fees are usually defined as the ‘cost of having your assets professionally managed’. How does this translate into the Venture Capital industry? VC funds typically pay an annual management fee to the fund’s management company, as a form of salary and a way to cover organizational and fund expenses. Management fees are usually calculated on a percentage of the capital commitments of the fund, or about 2 to 2.5 per cent.
  • Carried interest or carry: share of the profits of an investment or investment fund that is paid to the investment manager in excess of the amount that the manager contributes to the partnership. This is the way Wikipedia defines what a carry is. In plain English: when an investment is successful, a carry represents the share of the profits that is paid to the fund managers. Carried interesting in Venture Capital is usually 20 to 25 per cent, meaning that while 20% of the profits go to the general partners, 80% belongs to the limited partners.

How does this influence startups?

It’s important that startups recognize how Venture Capital firms work. As we’ve mentioned countless times before, investors back startups with one main objective in mind: getting a return on their investment. They’re in for the money, mostly.

It’s also worth noting that Venture Capital funds have a fixed life of about 10 years, thus establishing investing cycles that last for about three to five years. After that the firms will work alongside the startups and founders to scale and seek an exit, providing the returns that they sought in the first place.

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Photo | VentureBurn

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