A venture capital fund is a type of investment fund that invests in early-stage startup companies that offer a high return potential but also come with a high degree of risk. The fund is managed by a venture capital firm, and the investors are usually institutions or high net worth individuals. Below is a basic overview of a typical venture capital fund structure:
What is a Venture Capital Firm?
A venture capital firm performs a dual role in the fund, serving as both an investor and a fund manager. As an investor, they usually put in 1%-2% of their own money, which demonstrates to other investors that they are committed to the success of the fund.
As the fund manager, they are responsible for identifying investment opportunities, innovative business models, or technologies, and those with the potential to generate high returns on investment for the fund.
Roles in a Venture Capital Firm
Typical roles in a venture capital firm include:
General Partners: Responsible for all fund investment decisions and normally invest their capital in the fund.
Venture Partners: Source investment opportunities and are paid based on deals they close
Principals: Mid-level, investment-focused position. With experience in investment banking or other experience relative to the fund’s investment strategy
Associates: Junior staff with some experience in investment banking or management consulting
Entrepreneur-in-Residence: Industry experts who are hired as advisors or consultants to the venture capital firm temporarily, often to assist with due diligence or pitching new startup ideas.
Venture Capital Firm Compensation
Venture capital firms get paid through two revenue streams: management fees and carried interest.
Management fees are an annual payment made by investors to the venture capital firm to cover its operational expenses. The fee is usually around 2%.
Carried interest is a performance incentive paid to the venture capital firm whenever the fund realizes a profit, and typically is around 20% of the total profit distribution. The amount then gets distributed among the employees of the venture capital firm, with the majority going to the general partners.
Types of Venture Capital Funds
Venture capital funds often focus on an industry, market segment, financing stage, geography, or some combination of each. For example, a fund may only invest in US biotech companies or early-stage startups across multiple industries. Ultimately, the decision will come down to where the venture capital firm is most experienced and which areas are most attractive in current market conditions.
The Life Cycle of a Venture Capital Fund
Funds begin with a capital-raising period where the venture capital firm seeks out investors for the new fund. Depending on the firm’s reputation, market conditions, and fund strategy, the process can take months or even years. Once the targeted funding amount’s been reached, the fund is closed to new investors.
Afterward, the venture capital firm initiates a three- to five-year investment period in which the fund manager allocates the capital to investment companies and builds the portfolio. The focus shifts to managing the portfolio and providing the necessary resources to the investment firms to increase the odds of a profitable exit.
The total lifecycle of a venture capital fund lasts about seven to ten years, starting from the moment the fund is closed and ending once all deals are exited, and any profits are redistributed to the investors.
Return Generation and Exit Strategies
Unlike interest-bearing bonds or dividend-paying stocks, returns on venture capital investments can only be generated when a position is exited. The three most common ways to exit are:
1. Direct share sale
The fund sells its stake in the investment company to another investor or sells its shares back to the investment company itself.
In an acquisition, another company, usually a large one, purchases the investment company and, in doing so, buys out the venture capital fund.
3. Initial Public Offering (IPO)
In an initial public offering (IPO), the investment company goes public, and the venture capital fund sells its shares in the process.
While the returns on venture capital funds can be lucrative, there is a significant amount of risk involved in each investment. Most startups fail and can result in substantial losses to the fund – potentially, a total loss. The earlier the investment stage, the more risk is involved, as less mature, unproven businesses or technologies are more prone to failure.
Diversification is key to managing the overall risk of venture capital investments. Rather than concentrate on one or two investments, venture capital firms often invest in multiple businesses to spread their risk.
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