How Venture Capital Works

The principles of Venture Funding.

Venture capitalists are typically former executives or investment bankers who have turned to raising a private fund to make particular investments. A venture fund can be as small as $1 million to upwards of billions of dollars of investment capital. The capital for these funds can be contributed by multiple sources, including the VC’s themselves, but more typically this investment capital comes from large institutions with a lot of money that they need to invest, such as universities, insurance companies, state pension funds and other types of grouped investment sources.

The Lifespan of a Venture Fund

Venture Funds aren’t intended to live forever, with the average lifespan of a fund being about a decade. Many of the investments in venture funds tend to incorporate high growth startup companies that create a great deal of value in a short period of time. Therefore the fund needs to perform sooner than later in order to repay the commitments to those who have invested in the venture fund.

The VC’s Cut

Ideally the venture partners in the fund will make big bets that pay big dividends. But that isn’t the only way they make money. In addition to getting a piece of the upside for making good deals (usually 20%) the VC’s also get a “management fee” which often totals 2% of the total amount of the fund.

Over time the fund itself tends to “run out”, which requires venture capital firms to raise additional funds that create additional investing opportunities, and of course, additional management fees to the partners.

Trading Capital for Stock

Unlike a bank that will trade you debt for cash, venture capitalists are most interested in getting a stake in the company, typically in the form of equity. The goal of a VC investment is not to watch the company grow for decades, it’s to watch the company grow very quickly so they can convert their equity back into a much bigger pile of cash.

Ideally the VC is looking for the company to move to an Initial Public Offering (IPO) or a buyout. At this point the stake in the company that the venture fund acquired will (hopefully) become worth far more than it was originally valued at.

Not for Everyone

Venture Capitalists don’t invest in very many deals. By nature, they can’t. Most VC firms are limited to a few general partners or associates that must personally manage and monitor each and every one of their investments. This means that a small VC firm can handle maybe a dozen or so investments, but not many more.

At the same time they are being constantly barraged with investment opportunities. For this reason it’s not unusual for a VC to invest in 1 out of every 400 deals that they are presented with. The likelihood that your investment opportunity will be funded by a VC is relatively low, especially if you do not meet their particular investment criteria.

Investment Criteria

Many entrepreneurs overlook the fact that Venture Capital Funds tend to focus on very specific areas of interest (their “investment criteria”). For example, a VC may focus on investments strictly in biotechnology, or only on investments based in a particular area of the world. That’s because they are trying to align their investments with their expertise.

All of the investors in their fund are investing their money based on their appreciation for the Venture Partner’s particular expertise. If the Partners were to invest in bakeries when all of their expertise was in the aerospace industry, you would really have to question their abilities!

Although the number varies from fund to fund, it’s not uncommon for only 1 in 20 investments to become absolutely huge while the others perform moderately or not at all. Investing in one eBay or Google makes up for a lot of losers in the pipeline.