Venture Capital and Venture Capitalists, colloquially referred to as “VCs” are vital players in the world of startups and entrepreneurship. There’s a lot that founders don’t think about when it comes to venture capital, and a better understanding of the process is certainly advantageous to anybody seeking investment.
Traditionally a secretive practice, venture capital certainly has an air of mystery to it that might seem mystifying to outsiders. Regardless of whether you love them or hate them, founders will likely require venture capital to scale a business. Subsequently, founders need to know how a VC operates and what they are looking for, to position themselves most intelligently.
What are “Venture Funds”:
At the most basic level, venture firms/funds/groups are limited partnerships that require a collection of Limited Partners and at least one General Partner. Together, these individuals cooperate to raise funds from other investors (ranging from individuals, to family trusts, to institutional endowments), source deals, mentor and monitor portfolio companies, and (ideally) solicit/assist in reaching a desirable exit for a portfolio (in the form of an acquisition or IPO, mostly.)
Limited Partners (“LPs” as they are called) are investors in the fund and might play a role as passively as writing a check, or as actively as involving themselves in deal sourcing and mentoring.
General Partners (“GPs”) are effectively the founders of the firm, and are the central point of contact for LPs and for decision making – it is the GP that establishes the execution of the firm’s strategy and fundraising.
General Partners can potentially be liable for the debts of the partnership – because of this, GPs are usually set up themselves as a separate legal entity with limited liabilities. This is where is gets confusing in some cases, as the LLC structure permits/requires for overall structuring that might require more layers of liability protection for partnerships.
Venture firms make money in two ways: Management Fees and Carried Interest.
Management fees typically fall between 1%-2% per year of the raised fund. Most firms tend to operate on a ten year timeline, meaning the overall fee might total around 20% of invested principal. (i.e. a $10 million fund would have between $1-$2 million taken across ten years). The management fee goes towards paying salaries, overhead, and any other costs incurred in sourcing and closing deals.
Carried interest is the percentage of profits generated that the firm is entitled to. Usually around the 20% mark, with the remaining 80% of profits returned to investors. What this means is if a $10 million dollar firm returns $30 million over its ten year cycle, the overall profit is $20 million (principal returned to investors) with around $4 million to the firm itself, and the remaining $16 million distributed to the investors according to their stake in the original fund. The General Partner entity usually invests in each fund which means if $10k is put in for 1% of a $10 million fund that returns $20 million in profit – the investment becomes $200k, which is then distributed to partners.
In practice however, it’s not quite so simple. Most typically, the General Partner assigns the management fee to another LLC that acts as a management company that itself will administer the fund. This is done to prevent the management fee from mixing directly with the carried interest (this is done to protect income from law suits.) The management LLC remains throughout the life of the firm, while each fund-raise will have its own General Partner entity enabling new partners to join.
The overall percentages for both management fee and carried interest vary depending on the firm’s past performance and leadership team, current market rates, and industry (a bio-tech focused firm might charge differently than an agriculture focused firm etc.)
Why Founders Should Care:
The nature of the venture capital industry requires investments to find success within ten years or less, show continuing promise, and generate a healthy return. A prospective venture firm will look at your company at a basic level to determine if success seems likely within the desired time window, if there is a logical and realistic exit strategy, and if there equity can be acquired at a valuation that is favorable. This means a few key things to founders:
a) Don’t raise money too early and at too lofty of a valuation (this makes the company potentially unattractive to future investors who can’t justify the valuation). Over-boosted valuations can lead to difficulties in future fundraising, and can price you out of an exit.
b) Present a realistic exit strategy and your roadmap to achieve it. The firm can figure it out for themselves, but they will be happy to see that there is an achievable end goal for the founding team as well.
c) Focus on developing metrics and strategies to demonstrate the interim successes and milestones that will make a venture firm confident in presenting results to their LPs. This is because if a fund looks promising midway through, the firm can more readily raise another fund.
There’s far more that goes into venture capital and into a company positioning itself for investment, but if the aforementioned is taken into consideration it can only help. More broadly, every firm wants to see a defendable product that has the potential for large market share, led by a team with experience or expertise, and that also demonstrates promise in the form of traction/revenue early on. And when in doubt – traction trumps all.