Venture capitalism can be a very lucrative field to delve into – but there is much to consider. If you’ve ever wondered how a venture capitalist firm makes money, look no further. We’ve got the breakdown, below!
Venture capitalists invest funds (capital) in start-up businesses that have promise of high-growth rates, and in return, they claim a part of the company as their profit. The venture capitalists do not solely contribute to these funds invested. The majority of the fund comes from those called limited partners, and this includes financial institutes and other high-net-worth bodies.
The reason venture capitalists invest in growth-driven companies is that the more growth they drive, the more money the company is worth. And the more the company’s worth, the more its profit is in the end. So, when startup companies undergo any form of liquidity, either to trade with the stock market or to sell the company to the highest bidder, the venture capitalists can make more by selling the part of the company they own (shares).
What is Venture Capital?
Venture capital is a form of business financing that provides start-up businesses the capital to start and grow their businesses. These start-up companies are predicted to have exceptional growth potential, which benefits the venture capitalists more at the end of the investment year.
Venture capital is raised and provided by venture capitalists from investment banks, financial banks, insurance companies, and other financial bodies with high net worth. They don’t use their money, unlike Angel investors. About 99% of the total venture capital comes from these financial institutes, while the remaining 1% comes from venture capitalists. However, the venture capitalists decide on the companies to invest in that would give them the best returns.
Venture capitalists are more like a middleman between a startup company and a pool of investors (Limited partners).
Venture capital is not a long-term funding method. It is meant to fund a business from its early stages, when it needs to commercialize its products, with no value till it attains more credibility and value in the market.
Providing venture capital for businesses is not risk-free, although it may sound like it. Not all start-up companies later end up meeting the growth potential that they seem to exhibit during their first years. About 1 in 10 companies that capitalists invest in do meet and even exceed the set standards, and that’s how high the risks they take are.
A Brief History of Venture Capital
Venture capital firm was founded as a financial industry after World War 2 by Georges Doriot. He was a Harvard Professor and was regarded as the “Father of venture capital.” In 1946, he founded the American Research and Development Corporation, where he raised $3.5 million and invested in commercialized technologies.
His first investment was in a company whose goal was to create an X-ray technology as a cure and treatment for cancer. He invested $200,000 in the company, and his share went up to about $1.8 million once the company went public.
The Typical Structure of a Venture Capital Firm
A venture capital firm has a Limited Partnership structure between the limited partners and the general partners. These are the most senior members in the firm with investment and operational duties. The limited partners are formed by the pool of investors from whom the venture capital is raised. The general partners have included venture capitalists.
This structure is set in place by the Limited Partnership Agreement (LPA), which lays down the terms for the partnership. The terms include; the fund term, the investment period, debt, conflict of interest and time, investment restrictions, successor fund, management fees, placement fees, and many more.
The general partners are the primary decision-makers regarding the investments, and the limited partners have no say or control. However, the majority of the venture capital is contributed by limited partners.
What are Management Fees?
The management fee is the percentage of the venture fund that is contributed annually. It is usually about 2% of the venture fund(capital). Once the venture capitalists raise the venture capital from the limited partners, they charge the investors a typical 2% of the venture capital annually as management fees.
If, for example, the venture capitalists raise a total of $50 million for the venture capital, then the management fee would be 2% of $50 million, which is $10 million. A sum of $10 million is charged as a management fee yearly from the investors.
This percentage can, however, be reduced with time. After 5 years of investment, the management fee may become 1.8%, then 1.6% the year after, and so on.
The management fees vary concerning the total venture fund contributed—the more money raised or invested, the more management fees. The fund management company uses this management fee to cater to partners’ and employees’ salaries, audits, real estate, accounting, and other managerial aspects.
What is Carry?
Carry is the profit earned after several years of investment in a startup business. While management fee is gained from limited partners, carry is gained from investment in startup companies. It is more like a Return On Investment (ROI).
Once the venture capital invested reaches its end date, it undergoes some form of liquidity/exit by trading on the stock market or selling to company acquirers. After this, the initial fund is distributed to all investors; the venture capitalists charge 20% of the profit.
Let’s say the total money invested in the company is $50 million, and after liquidity, the company has a profit of $100 million. Once the $50 million has been distributed, the venture capitalists charge 20% on the $100 million profit generated.
Other Variables to Consider for VC Firms
Before operating a VC firm, other variables need to be considered to avoid failure and disappointment. They include:
- Not all startups succeed: As I mentioned above, investing in a startup company is high-risk, and venture capitalists know this too. Out of every 10 companies invested in, only about 1 succeeds. This is an important variable to take note of.
- Management fees vary: As an investor, it is vital to know that management fees might vary depending on how prestigious and popular the venture capitalists are. However, the typical fee is 2%. This doesn’t mean that it can’t get higher than that.
- Venture capital is structured as a limited partnership between the Limited Partner and the General Partner.
- Venture capitalists earn money in two ways; Management fees and Carry.
- Providing venture capital for businesses is risky, but successful companies are profitable and rewarding.
If you would like to know about venture capital and how it works, contact us via intrepidfinance.io.