Venture capital investors fall under the category of limited partnerships. This means it limits them in the amount of control they have, and the amount of money they can earn. These limits are outlined in the initial contracts prior to the funds being offered to the company. It is important to make sure you fully understand the contracts you are entering with any types of venture capital investors.
Who invests in venture capital funds?
Parties that invest in VC funds are known as limited partners (LPs). LPs are high net worth individuals, institutional investors, and family offices.
Breakdown of LP Capital Invested in VC Funds: Pension funds, endowment funds, etc. Institutional fund managers will invest some capital within VC funds, with the goal of achieving a certain overall percentage of return (say, 15% increase) each year
Small percentage from high net worth individuals: Individuals with a net worth of over $1 million in liquid assets who invest their personal wealth in startups or VC. Many VC funds limit participation to individuals who clear $5 million in net worth.
EXAMPLE: David F. Swensen, manager of Yale’s $25.4 billion endowment fund, pioneered a groundbreaking investment strategy in 1976. He diversified the fund, then composed of stocks and bonds, by including multiple asset classes, and led Yale to become one of the first universities to invest in venture capital.
Venture capital became Yale’s best performing asset class, generating a 33.8% annual return from 1976 to the present day. Yale’s endowment fund is packed with tech giants like Amazon, Google, Facebook, Pintrest, Snapchat, Uber, Twitter, and Airbnb.
Venture capital now makes up 16.3% of Yale’s overall investment portfolio, and its endowment fund generates of the university’s overall budget (as opposed to 10%, before Swensen’s management).
Institutional fund managers will invest some capital within VC funds, with the goal of achieving a certain overall percentage of return (say, 15% increase) each year Small percentage from high net worth individuals. (fundersclub.com)
Who manages venture capital funds?
VC firms will typically use one or many fund managers, or general partners (GPs) to run their funds. GPs make smart investment decisions and maximizing returns for the LPs who invest in the funds they manage.
GP responsibilities include:
- Raising funds from LPs - Sourcing top startups - Performing - Investing fund capital in high-promise startups - Delivering returns to investors in the fund (LPs) - Providing value-add to fund portfolio companies beyond just capital, including introductions, advice, introductions to follow-on investors, etc.
VC funds are large, ranging from several million to over $1 billion in a single fund, with the average fund size for 2015 coming in at $135 million Investing in larger VC funds comes with advantages and disadvantages.
- Experienced VCs with inside knowledge manage your investments
- Most large funds include a diverse base of companies
- The fund has on-hand to deploy to successful portfolio companies looking to raise additional funding, which maximizes the investors’ equity stake in already proven, successful companies
- Large funds invest in later-stage startups, which have a lower risk of failure than seed and very early-stage companies
- Huge funds frequently cannot deliver market-beating returns, as there is sometimes more capital to deploy than high-promise startups to invest in
- Large funds are less likely to invest in early stage startups, which are a riskier investment than later-stage startups, but have a greater potential for outsized returns.
Like individual startup investors, fund managers diversify each VC fund by investing in multiple startups within different industries, to maximize their chances of landing on a startup that generates returns which more than compensate for all failed investments.
VC funds are structured under the assumption that fund managers will invest in new companies over 2-3 years, deploy all (or nearly all) of the capital in a fund within 5 years, and return all capital to investors within 10 years.
Funds have a long lifetime because it usually takes years for the startups they invest into mature and grow in value. For example, GPs will hold off on closing out a fund by liquidating the investments within it if a liquidity event has not yet occurred for promising startups within the fund.
In exchange for investing your money and managing the fund, VC firms typically charge management fees and carried interest (carry), on a percentage of the profits made on fund investments.
This is referred to as the model: VCs typically charge 2% of the total fund size per year for management fees. The operational and legal costs required for the fund to operate; and 20% carry on any profits the fund makes.
Top VC funds sometimes use a 3-and-30 model, and can justify these higher fees because their track record still leaves investors with greater net returns.
EXAMPLE: In 2003, the Sequoia Venture XI Fund raised $387 million from about 40 LPs, mainly institutional investors.
In 2014, Sequoia closed the fund, and reported $3.6 billion in gains, or a 41% annual return.
Sequoia partners collected $1.1 billion in carry, 30% of all the gains, while LPs received $2.5 billion, 70% of the gains.
Venture capital investors are more than willing to provide money to various businesses for these benefits. They take risks others won’t and often can successfully turn it into large amounts of profit.
Why do startups raise VC Money?
Venture capital is an ideal financing structure for startups that need capital to scale and will probably spend a significant amount of time in the red to build their business into an extraordinarily profitable company. Big name companies like Apple, Amazon, Facebook, and Google were once venture-backed startups.
Unlike car dealerships and airlines, companies with valuable physical assets and more predictable cash flows. Startups typically have little collateral to offer against a traditional loan. Therefore, if an investor were to issue a loan to a startup, there’s no way to guarantee that the investors could recoup the amount they’ve lent out if the startup were to fail.
By raising venture capital rather than taking out a loan, startups can raise money that they are under no obligation to repay. However, the potential cost of accepting that money is higher. While traditional loans have fixed interest rates, startup equity investors are buying a percentage of the company from the founders. This means that the founders are giving investors rights to a percentage of the company profits in perpetuity, which could amount to a lot of money if they are successful.
Startup Fundraising Rounds: Seed to Series C and Beyond
Startups raise venture capital in phases, commonly referred to as “rounds”.
Startup fundraising “rounds” refer to primary issuances of venture capital, instances when investors get a lot of capital together and invest in in the startup in one shot, or, in two or more increments, known as tranches Each fundraising round goes with a new stage in a startup’s development, and is often tied to a valuation event (events that affect a startup’s worth, based on the price per share one would have to pay to invest in the company).
Rounds typically range from less than $1 million to $3 million dollars.
Have showed early traction; need capital to continue product development and gain an initial customer-base.
Series A Round
Rounds typically range between $3 million to $10 million.
Usually have achieved strong product-market fit; seeking additional capital to scale their customer/user base and increase revenue.
Series B Round
Rounds typically range from $5 million to $25 million.
Startups should be able to show highly measurable results (strong revenue, large market share, repeatable growth engine); focused on scaling their internal team and achieving market domination.
Series C and later-stage startups
Rounds range from over $10 million to $100 million.
Can show a large-scale expansion; focused on developing new products or expanding into new geographies. Subsequent rounds labelled Series D Series E, and so on, and can be spaced around 18-24 months apart.
Part of the reasons venture capital investors can make money is they don’t just sit back and watch things unfold. It may involve them in the decision-making processes because of the amount of stock they hold in the company. This is a benefit to the new company though as this may make the difference between them being successful and them failing.