How do VC funds work?

Understand how Venture Capitalists operate & make money.

A cheatsheet by @nathan-appere|Refreshed 5 months ago.Refresh|View source on Github

Limited Partners

Limited Partners

VC firms get their money from Limited Partners (LPs).

They are often financial institutions (banks, foundations, pension funds, big corporations, etc) or high net-worth individual investors.

Expected return

Expected return

VC funds are a high risk asset class, so a respectable return for a VC fund is 20% per year (a minimum return is around 12% per year).

For comparison, less risky investment (real estate, stock market) can return a “safe-ish” annualized 7-8%.

If the fund life is 10 years, the minimum return on investment for an annualized 20% needs to be 1.20^10 = 6x (for 12%: 1.12^10: = 3x)

Fund life

Fund life

Most funds last 10 years (+ 1-3 years extensions), and only actively invest for 2-5 years.

VCs raise a new fund every two to three years so the return profiles of their previous funds are not always clear.

Final net metrics are only obtained after all investments have been realized (exited), all distributions have been made to the LPs, and the fund is fully liquidated.

The management fees are used to pay for the fund operational expenses & compensation (salaries, offices, travel, etc.).

2% management fee

2% management fee

This is charged every year of the fund’s life (≃ 10 years).

So on average a standard VC firm will charge 20% of the fund’s total raised capital in management fees and will invest the remaining 80% in companies.

20% carried interest

20% carried interest

Also called “carry”, this is a profit-sharing split.

Returns in excess of the original investments (aka profit) is typically divided between the Limited Partners and the VC firm in an 80/20 split (the “twenty”).

Hurdle: LPs can sometimes insist on a certain rate of return before VCs can take carry.

Implications for investments

Implications for investments

With 80% of the fund raised capital available for investment, half is left aside for follow on investments.

This means VCs only end up deploying ~40% of the total amount of funds they raise into new investments.

Returns

Returns

In a typical fund, 80% of returns come from 20% of startups.

Because of this (and the minimum expected return), VCs will almost certainly block a sale of the company unless the price gives them a 10x to 30x return.

Carry

Carry

There are 2 models for VCs receiving cash from exits:

  • American Waterfall: carry is distributed on a deal by deal basis and may be clawed back from VCs (favors GPs).
  • European Waterfall: capital has to be returned to LPs at a fund level before carry is distributed (favors LPs).

End of fund life

End of fund life

Once a fund reaches the end of its designated life time, VCs are pressured to get their stakes to be liquid in order to distribute the returns, get their carry, stop charging the yearly management fees.

If their ownership stake has been written down and they don’t see an exit anytime soon VCs may just write off the investment or sell the stock in a secondary transaction.