Venture capital – often referred to as ‘VC’ – remains one of the most popular sources of financing for startups. With venture capitalists pouring billions of dollars into early-stage businesses, VC has transformed into a critical part of the startup ecosystem. In this short guide, we’ll touch on the world of venture capital, exploring what venture capital firms and funds are, how venture capital firms make money, the different types of venture capital firms, and how VC compares to other investment strategies.
What is a Venture Capital Firm?
A venture capital firm is an investment firm that provides capital, mentorship and other support to startups in exchange for equity (or debt). The firm is managed by professional investors who target companies with high growth potential. Venture capital firms bring expertise and knowledge to the startups they invest in, offering guidance on strategic planning, product development, hiring, and fundraising. They also help startups connect with other investors, customers, and industry experts, which can be invaluable to a startup.
What is a Venture Capital Fund?
A venture capital fund is a pool of money raised by a venture capital firm from investors. The fund is then used to invest in startups. The fund is typically structured as a limited partnership, with the venture capital firm acting as the general partner (usually abbreviated to ‘GP’) and the investors acting as limited partners (or simply ‘LPs’). The general partner is responsible for making investment decisions and managing the fund’s portfolio, while the limited partners provide the capital. Although the fund is typically structured as a limited partnership, other structures can also be used, such as a corporation, LLC, or trust.
How Venture Capital Firms Make Money
Venture capital firms make money through a combination of management fees and carried interest.
The management fee is a fee charged by the venture capital firm as a percentage of the total amount of capital committed to the fund. It is used to cover the operating expenses of the firm, such as salaries, office rent, and other expenses. The management fee is typically around 2% per year, but can vary depending on the size of the fund, the investment strategy and other factors.
Carried interest is a share of the profits generated by the fund that is paid to the general partner. It is typically calculated as a percentage of the profits earned by the fund above a certain threshold (the ‘hurdle’). For example, a venture capital firm may agree to a “2 and 20” fee structure, which means they charge a 2% management fee and a 20% carried interest on the profits earned by the fund. This means that, if there is no hurdle and the fund earns $100 million in profits, the general partner would receive $20 million as carried interest.
Calculating carried interest depends on the terms of the fund’s documents. Two common structures are the ‘American waterfall’ and ‘European waterfall’. For the American waterfall, profits are distributed on a deal-by-deal basis as each investment is realised. This means the general partner receives carried interest for every profitable exit. For the European waterfall, profits are distributed on a whole fund basis. This means the general partner receives carried interest only if the fund is profitable overall. The choice between these waterfall structures will depend on the specific goals and priorities of the venture capital firm, fund and investors.
Both management fees and carried interest are important sources of revenue for venture capital firms. The management fee ensures that the venture capital firm has the necessary resources to operate and invest in startups. The carried interest aligns the incentives of the general partner with the limited partners, as it rewards the general partner for generating positive returns on investments. To further align incentives, some funds may require the venture capital firm to invest alongside LPs (known as a ‘GP commitment’), as this helps to ensure the firm has (financial) skin in the game.
Different Types of Venture Capital Firms
There are several different types of venture capital firms, each with its own investment focus and strategy. Here are some common types of venture capital firms:
- Early-stage venture capital firms: These firms invest in startups in the earliest stages of development, typically providing seed funding or Series A funding. They are often willing to take on more risk in exchange for a larger potential return on investment.
- Late-stage venture capital firms: These firms invest in startups that are further along in their development, typically providing Series C or later funding. They are often more interested in startups that have demonstrated market traction and are closer to achieving profitability.
- Industry-specific venture capital firms: These firms focus on investing in startups in a particular industry or sector, such as healthcare, fintech, or cybersecurity. They bring specialised knowledge and expertise to the startups they invest in and are often well-connected within their industry.
- Corporate venture capital firms: These firms are backed by corporations and invest in startups that are strategically aligned with the parent company’s business interests. They may also provide startups with access to the parent company’s resources and expertise.
- Social impact venture capital firms: These firms focus on investing in startups that are working to address social or environmental challenges, such as climate change, poverty, or healthcare access. They are often interested in startups that have a strong social or environmental mission, in addition to a promising business model.
Each type of venture capital firm has its own investment thesis and criteria for selecting startups to invest in. Some venture capital firms may focus on specific geographic regions, while others may have a global investment mandate. Overall, the diversity of venture capital firms allows startups to find investors that are a good fit for their particular stage of development and industry focus.
How VC Compares to Other Investment Strategies
Venture capital is just one of many investment strategies available to investors. Here is how VC compares to other popular investment strategies:
- Public markets: One of the most significant differences between VC and investing in public markets is the level of liquidity. Public markets provide investors with easy access to buy and sell their investments, whereas VC investments are usually illiquid, meaning it may take several years to see a return on investment.
- Private equity: While both VC and private equity (‘PE’) invest in private companies, there are some key differences. PE typically invests in established companies with a proven track record of revenue and profitability, while VC invests in earlier-stage companies with the potential for rapid growth. PE deals also tend to be larger than VC deals, and PE investors typically take a controlling stake in the company.
- Angel investing: Angel investors typically invest in the earliest stages of a startup, often before VC firms get involved. Angel investors are usually individual investors who provide funding and mentorship to startups in exchange for equity.
- Crowdfunding: Crowdfunding allows startups to raise capital from a large pool of individual investors via online platforms. However, crowdfunding usually involves smaller investments than VC, and investors may not have the same level of due diligence as VC investors.
Overall, VC offers investors the potential for high returns, but it comes with higher risk and less liquidity than some other investment strategies.
Closing thoughts
Venture capital firms, and their funds, typically invest in startups that are not yet profitable, meaning there is a very high risk of failure. However, if a startup succeeds, the returns can be significant. Venture capital is a vital part of the startup ecosystem, providing entrepreneurs with the funding and support they need to grow their businesses, whilst providing investors with financial exposure to promising startups.
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