Venture Capital is a form of a financing that 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).
A venture capitalist will raise money from rich people called Limited Partners (LPs). These can be individuals, families, corporations, and other funds who invest in funds, etc. Then they will take that money and on the other side, invest in start-ups.
Have it in mind that the promise or hope is that some subset of those start-ups will grow exponentially, and then through some sort of liquidity event — it could be an acquisition or an IPO or even a way to sell shares to someone else in a secondary sale, the venture capitalist will receive back a lot more cash than initially invested. That cash then gets returned back to the initial investors and the venture capitalist makes some money in between.
Have it in mind there are two major elements within a VC fund: general and limited partners. The general partners are the individual tasked with making investment decisions (finding and agreeing to terms with start-ups and companies) and working with start-ups to grow and meet their goals. While there are limited partners, the people, and organizations that provide the capital required to complete those investments.
Simply put, general partners make the investments, and limited partners provide the funds. Have it in mind that 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 percent of the size of the fund.
It is important to remember that venture capital firms are also businesses just like the companies they invest in. While venture capitalists do want to help a company be successful, they are really in the business of raising more venture funds.
Venture firms are driven to build the most oversubscribed venture fund and make a lot of money doing it. However, a venture fund’s business model is quite different from traditional businesses. If you learn how venture investors make money, you’ll understand what motivates the decisions they will make while working with your company.
Smart Ways Venture Capitalists Make Money
The ways Venture Capitalist makes money are twofold: via management fees and carries (carried interest).
The first way venture investors make money is from a management fee. A venture fund is a pool of capital invested by high net worth individuals, fund of funds, endowments, retirement funds, etc. And just like it was explained above, these investors in a venture fund are known as Limited Partners or LPs.
When a venture capital firm raises capital, it charges its LPs a fee for having venture investors invest and manage investments in start-ups. Traditionally venture funds are known to charge their investors 2 percent per year of the total value of a fund.
If, for instance, the venture fund $100mm, the venture firm will earn $2mm per year to pay salaries and other operational expenses of the fund ($100mm * 20 percent = $2mm per year).
Have it in mind that management fees become more lucrative to venture investors when a venture firm manages multiple funds simultaneously. A normal venture firms try to raise a new fund every 2 to 3 years with the lifespan of a fund being 7 – 10 years.
Most times, you’ll see in tech publications that “Great VC” has just closed its new $100mm fund called “Great VC II”. It simply means that Great VC has raised its second fund and is likely still managing its first fund: Great VC I and now Great VC II.
Let’s assume that Great VC has two active funds at $100mm each. Assuming the same 2 percent fee, Great VC is making $4mm per year in fees for managing two $100mm funds (2 funds * $100mm * 2 percent = $4mm).
Carried interest or carries
This is simply part 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. Carried interest is the most lucrative way a venture investor makes money.
Traditionally, venture investors earn 20 percent carried interest on their fund. That means if a fund’s size is $100mm, venture investors earn $0.20 on every dollar earned over $100mm. So if a venture fund can return $300mm on their $100mm fund, they will earn $40mm in carried interest (($300mm return – $100mm original investment) * 20 percent = $40mm).
There is more money than ever in the start-up funding market across all funding stages. As we have mentioned above, investors back start-ups with one sole objective in mind: getting a return on their investment. They are in for the money, mostly.
You should also note 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 start-ups and founders to scale and seek an exit, providing the returns that they seek in the first place.