Venture Capital Investment - Explained
What is Venture Capital?
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Table of ContentsWhat are Venture Capitalist and Capital Funds?Venture Capital Portfolio CompaniesHow is the Venture Capital Fund Structured?Compensation with the Venture Capital Fund
What are Venture Capitalist and Capital Funds?
Venture capital funds are pools of funding used to purchase equity interests in growth-based, startup ventures. The venture capitalist is the fund manager who raises funds (raises a fund) from investors seeking to allocate a portion of their investment portfolio to investing in higher-risk (and higher potential return) investments. Venture capital funds may vary in size to meet the class of investment desired by the fund investors.
Generally, venture capital funds look for investments in excess of $1 million dollars. Even large funds rarely make investments in a single startup in excess of $100 million. The fund has a fixed duration (generally 7-10 years) and will invest in multiple startup ventures throughout that period. The investments are generally staggered with hopes of receiving staggered returns throughout the firms lifecycle.
As previously discussed, investors in startup ventures seek a return on investment via some future exit event. Common exit events include, future equity funding rounds, sale to a strategic acquirer, or an initial public offering. The venture capital firm will seek to exit (and reap a profit from) the investment within 3-7 years (during the life of the venture fund). As such, most venture capital fund investments occur within the first 5 years of the firms life.
In theory, the fund will return profits to investors during the second half of the firm life. Often these investors will re-invest the profits in another venture capital firm that runs collaterally to the present firm. The objective is to always offer an investment option for the fund investors.
Back to: Business Transactions
Venture Capital Portfolio Companies
The venture capital firm will generally seek to invest in approximately 10 startups in a given fund. History dictates that 6 of the investments will fail to return the funds capital. 3 of the startup funds will break even and make a nominal return to the fund. 1 or 2 of the portfolio companies will have a large return that carries the fund to profitability. Generally, a venture capital firm will generate a 25% Internal Rate of Return for its investors. To achieve this return rate, the successful startup must generate between 10x and 50x the initial investment of capital.
Back to: Entrepreneurship
How is the Venture Capital Fund Structured?
In its most basic form, venture capital funds are organized as limited partnerships. For more information on how limited partnerships work, see our business entities lecture series. The managers of the firm are the general partners in the limited partnership.
Generally, the managers form a business entity (generally an LLC). This LLC may acts as the general partner in the the limited partnership. Investors are the limited partners in the partnership. The investors may be named individually as limited partners, but this is rare. Generally, investors group together to form one or more business entities (generally LLCs). The business entities then invest funds into the limited partnership and act as the limited partners.
Because the business entity is always a flow-through tax entity, it allows for proceeds from investment to flow through to the investors without entity-level taxation. Further, these layers of business entity help protect the fund managers and investors from personal liability in the event the venture capital fund becomes subject to lawsuit.
Lastly, this structure allows for the efficient allocation of authority and other tax advantages when distributing proceeds.
Compensation with the Venture Capital Fund
Managers of a venture capital fund receive a management fee for investing and managing the funds contributed to the pool. The management fee generally covers all expenses associated with managing the fund and pays the managers a salary. The management fee is generally 2% of the fund value.
All investor funds are not held in the fund at once; rather, funds are called down from investors as needed. This reduces the standing management fee that managers collect. Also, the management fee is generally subject to a sunset provision, which terminates management fee payments after a stated number of years.
Managers also receive a percentage of the profits (capital gains) achieved when exiting the startup (i.e., selling the equity interest in the startup). The managers generally receive 20% of the profits achieved. The gross proceeds from sale of the venture are generally distributed as follows:
- Investors receive in full the amount of funds originally invested in the venture capital fund.
- Investors may receive additional funds to match the management fee paid to managers.
- Investors may then receive any preference multiple (1x, 2x, 3x, etc.) of their money invested.
- Note: There may not be a liquidation preference for fund investors.
- Remaining proceeds are split between investors and managers.
- Note: As previously noted, managers generally receive 20% of additional proceeds. This amount may be far higher if the investors first receive a liquidation preference.
A huge benefit to the managers is that the 20% proceeds received are taxed at a carried interest rate (15%), rather than an ordinary income rate.