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How Does a Venture Capital Firm Work?
Venture capitalists are paid to take risk—or at least that’s how it’s supposed to work.
Venture capitalists are paid to take risk—or at least that’s how it’s supposed to work. VCs are compensated based on the success of the companies they back, but they also make more money when they manage larger funds. In "The Decade That Completely Transformed Venture Capital," I explained how VC has changed in the last decade. This article covers the basics: how VC firms work, how they invest, and how they make money.
Who works in venture capital
The two most important groups of people in the venture capital industry are limited partners and general partners. The limited partners don’t work for the VC firms; they’re the ones who provide the money for the venture firm to invest and manage. This group is dominated by university endowments, state investment groups like pension funds, foundation endowments, funds of funds, and family offices.
The general partners are the VCs themselves. Venture firms are typically partnerships made up of the most senior staff who make and manage investments. The structure of the general partnership varies widely from firm to firm. Some firms like Benchmark and CRV have equal partnerships where each partner has the same economic interest. But most firms have some level of seniority whereby the founders of the firm or the most senior partners receive higher compensation than the rest—sometimes significantly higher.
VC firms also employ non-partner staff including junior-level investors and analysts who help source and manage investments, as well as people who manage the firm’s finances, administration, and marketing. Some larger funds also provide consulting services like recruiting, design, marketing and business development to help the companies they invest in grow.
How VCs invest
The general partner’s job is to invest in companies that will—they hope—grow and create a positive return when the investment is returned. The details of how a VC invests differ based on the stage of the company, but the primary investment method is purchasing a minority of the equity of the company.
For example, a VC might invest $5 million as part of a $10 million Series A at a $25 million pre-money valuation in exchange for 14% of the company’s stock. The company’s value is its pre-money valuation ($25 million) plus the value of the new investment, in this case $35 million. In this example, the rest of the $10 million investment comes from other investors; one VC firm will typically “lead” a round, setting the terms and investing the most money, with others “following” by investing smaller amounts.
Usually, a VC purchases preferred shares which give the investor “preference” or superiority over the common shares owned by the company’s founders and employees. Preferred shares get their name from their liquidation preference — meaning, the owners of preferred shares get preferential treatment if a company is liquidated or sold. The most basic preference is usually that shareholders get their money back first. So, if a VC firm invests $5 million in a company, it will get that $5 million back before any capital is distributed to anyone else. Some VCs also ask for an enhanced preferred return which could be a multiple of the capital invested (i.e., the VC gets 2x of its capital back first) or it could mean a return that includes interest on top of the capital invested (i.e., the VC gets its capital back plus 10% interest per year).
The advantages of preferred shares aren’t limited only to financial returns though. Preferred stockholders usually also have the right to:
- One or more seats on the company’s board of directors
- Participate in future fundraising rounds to maintain their ownership percentage (this is called a pro rata right). For instance, if a VC owns 20% of a company, this gives them the right to invest more money in each successive fundraising such that they continue to own up to 20%.
- Purchase any stock that becomes available in the market (a right of first refusal)
- Sell stock alongside any sale of common stock (a co-sale right)
- Adjust the price of their stock down if a future fundraising is at a lower valuation (an anti-dilution right)
- Information about the company to monitor their investment
How VCs exit their investments
Over the past decade, venture investors have made 56% of their returns by selling investments to the public markets (following an IPO), 40% by selling to larger companies through acquisitions, and 4% by selling to other investors through buyouts. These numbers are heavily influenced by the big unicorn IPOs in 2019, though. Total returns for the decade ending 2018 were split 49% from IPOs, 47% from acquisitions and 4% from buyouts. While buyouts have remained a relatively small portion of total returns, the number of deals has increased significantly from 9% of total exits in 2010 to 20% of total exits in 2019.
VCs, along with other insiders like founders, typically agree not to sell any shares for 90 to 180 days following an IPO (called a lock-up period). This restriction is meant to reduce the number of shares offered for sale that can put downward pressure on share prices. Holding shares post-IPO exposes VCs to the risk that share prices will decline before they sell, as was common with unicorn IPOs in 2019. This can make acquisitions an attractive alternative since they don’t have the same price risks.
How VC firms make money
Dating back to the early 1970s, the economics of the venture industry has generally followed a structure called “2 and 20,” representing a 2% management fee and 20% carried interest. Once a fund is established, the general partners collect 2% of the total fund size each year as a management fee to cover expenses—primarily the salaries of the partners and staff. When the firm decides to make an investment, it will “call capital” from the limited partners to cover the amount of investment. If the fund makes profits on its investments, the general partners keeps 20% of those profits, called carried interest or simply “carry.” These economics vary from fund to fund though. For instance, some prominent firms have fees as high as 3% and 30% while some multi-billion dollar growth funds have management fees as low as 1% per year.
Funds generally have a 10-year lifetime with two two-year extensions if the fund has investments that still need to be managed. Management fees usually decline as investments are liquidated since there is less capital to manage. The general partner typically invests all of the capital within the first few years and then manages the investments for the remainder of the fund’s lifetime. The general partner isn’t limited to only one fund, though. On average, venture capital firms raise a new fund every three years which means that each partnership will be collecting fees from multiple funds at a time.
Let’s walk through an example: let’s say that ABC Ventures raises a $100 million fund. The general partners collect $2 million per year to run the fund for the next 10 years. (For simplicity we’ll assume the fees do not decline and that there are no fund extensions.) Let’s then say that ABC Ventures is successful and returns $300 million to its investors: $100 million of original capital returned plus $200 million of profits. The general partners would keep 20% of the profits, or $40 million.
Let’s also say that ABC Ventures raises a new $100 million fund every three years. By the sixth year, the partners of ABC Ventures would be collecting $6 million per year in fees and would be anticipating $120 million in carried interest if all three funds were as successful as the first. In this scenario, the partners would collect around $180 million or an average of about $10 million per year over the lifetime of the three funds. Add to that the fact that carried interest is taxed at the capital gains rate and you can see why this is a good business to be in if a venture firm manages enough capital.
Many venture firms are quite small, however, making the economics more challenging. There’s an old adage that the optimal amount of capital per partner starts around $25 million. At this amount, there will be $500,000 of management fees per partner to pay expenses. If you reverse those numbers and consider a $25 million fund with four partners, there will be only $125,000 of management fee per partner. After operating expenses, these funds may have very little left to pay the partners. In these cases, it’s safe to assume that the partners have other sources of income to live off and are hoping and betting on generating income through carried interest.
It’s also important to note that venture firms need to make money for their investors in order to raise multiple funds. Given that venture investments usually take several years to generate returns, some firms will be able to raise two or three funds based on investments that haven’t generated returns yet but look promising. In the past, this has meant that some firms have raised millions, and even billions, of dollars without generating profits. But there are limits. Eventually, a firm has to return profits to its investors or limited partners will refuse to invest.
How convertible loans work
At times, venture investors also loan money to startups, primarily through convertible debt (aka converts). This type of loan accrues interest but can also be converted to equity given certain circumstances; the primary reasons to convert are raising a new round or a sale of the company. Converts are popular for angel and seed investing and these investments usually convert at a valuation that’s a discount to the next equity round.
A new flavor of convert called the Simple Agreement for Future Equity or SAFE was introduced by accelerator Y Combinator in 2013. Unlike a typical convert, the SAFE doesn’t accrue interest but operates similarly to a convert in other ways. Importantly, Y Combinator made the SAFE agreements publicly available, allowing them to be used by others and become the de facto standard for angels and seed investors in the Bay Area.
Corporate VCs and “alternative” VCs
Venture firms aren’t always independent organizations. For instance, many technology companies have venture groups, most notably Google Ventures, Intel Ventures, and Salesforce Ventures. These “corporate venture” groups are similar to independent venture firms in the way they make investments, but they have two major differences. First, corporate VCs frequently invest in startups that will have a strategic benefit to the parent company. Second, corporate venture groups don’t have the same management fee and carry compensation structure.
Public-market investors like hedge funds, mutual funds, and investment banks also participate in venture deals. These investors tend to be opportunistic venture investors, making more investments when they think returns in the private markets will be better than the public markets and less when they don’t. Key players include mutual funds like Fidelity Investments, hedge funds like Tiger Global, and investment banks like Goldman Sachs.
Any list of alternative VCs would be incomplete without mentioning Softbank’s Vision Fund, the $100 billion behemoth that’s part of the Japanese conglomerate holding company, Softbank. The Vision Fund’s scale, which allows it to invest hundreds of millions in dozens of companies, has singularly changed the late-stage venture market. Following WeWork’s failed IPO, though, Softbank has slowed its investment pace and even backed away from some deals. The venture community is watching closely as Softbank attempts to raise its second Vision Fund since any change to the size of or strategy of Softbank’s funds could have wide-ranging impacts across the venture market.
Originally published in Quartz.