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A Nuts & Bolts guide to Venture Capital

Adapted from Joe Hadezima's presentation at MIT Sloan School (Course 15.S21)

Where does VC Money come from?
  • Venture Capital Firms raise money from Insurance Companies, Educational Endowments, Pension Funds and Wealthy Individuals.
  • In turn, these organizations/individuals have an investment portfolio which they allocate to various asset classes (equities, bonds, real estate, etc). One of the assets classes is called 'Alternative Investments.' Venture Capital is one form of an alternative investment.
  • Typically, 5% to 10% of the portfolio might be allocated to Alternative Investments, which is considered a high risk, high return investment. 
How are Venture Capital Funds Organized?
  • General Partners ('GP')These are the 'Venture Capitalists' who manage the fund and investments. They typically come from an entrepreneurial or financial background. financial types.
  • VC Fund: The General Partners use an Offering Memorandum to raise a fund of a given size from the Limited Partners by convincing them that the GPs have a unique strategy or expertise in a particular sector or sectors of the market. Fund raising can take a year or more until the fund closes.This occurs where the funding commitments from general partners meets the fund size.
  • Limited Partners ('LP')Pension Funds, Educational Endowments, Foundations, Insurance Companies, Wealthy Individuals who are interested in investing in alternative assets as part of the investment portfolio. 
What is the role of the General Partner / VC?
  1. Source Deals: The GPs have to find investment opportunities, typically by referrals from trusted sources.
  2. Make Investment Decisions: From the opportunities identified the GPs pick “winners.” These typically reflect 1-2% of opportunities surveyed.
  3. Manage The Investment: The GPs have a fiduciary duty to the LPs to “manage” the investment. This means they usually sit on the Board of Directors. This requirement typically limits the portfolio size at any one time to 6 to 10 investment companies.
  4. Harvest The Investment: the GPs win if they can get secure an exit for the investment. This usually takes the form of an acquisition or Initial Public Offering (IPO). The typical win rate of a vetted companies is typically less that 1 in 3.
What is the role of the Limited Partner?
None, other than providing capital. This  commitment occurs in two stages:
  1. Capital Commitments: The LP commits to contribute an amount of capital when called upon. 
  2. Capital Calls: When the GP/VC has discovered an investment opportunity, they will call on the LP to contribute pro-rata to their commitment
By way of example, a fund of $100m which has an LP with a Capital Commitment of $10m (ie 10% of fund) will have to pay up a Capital Call of $1m when a $10m investment is made.
How do VCs make money?
The General Partners make income in two ways:
1) Management fees
  • An annual Management Fee, which is usually a percentage (typically 2.5%) of the Capital Commitments to the Fund.
  • This fee covers the operational expenses of the General Partners (salaries, admin, etc)
2) Carried Interest
Once the VCs make investments, they tend to harvest the investment following 3 to 7 years. The returns from the investment are typically split as follows between the Limited Partners and the General Partners.
  • The Limited Partners receive 99% of all the returns and the GP/VCs receive 1% of all returns
  • Once the Limited Partners receive back 100% of their Capital, the VC is entitled to 20% (up to 30%) of returns over and above that mark. This is called the GP’s “Carried Interest.”
Fund Investment Cycle
Fund Life
  • Most Funds have a 10 year life. At the end of 10 years they are liquidated.
  • Funds plan to harvest winners in 5 to 7 years or less.
Initial Portfolio Investments
  • A fund usually makes its initial investments in the first 3 years of the Fund life cycle.
  • An early stage fund will usually allocate a quarter to a third of the fund for initial investment
  • During the remaining life of the Fund follow-on investments are made and the portfolio companies are positioned for “harvest”
Follow-on commitments
  • As stated above, Early Stage Funds typically reserve $2-$3 for every $1 invested for follow-up commitments.
  • For example, if the Fund invests $2m in Round 1, they will reserve another $4m -$6m for follow-on rounds. A $100M Fund might invest $25M in the first rounds of portfolio companies and $75M in follow on rounds.
  • This approach allows the fund to cherry pick 'winners.'
Follow-on funds
  • Once initial investments have been made in Fund 1, VCs are motivated to raise Fund 2 enabling them to invest in new opportunities (and get additional Management Fees).
  • Through this layering of Funds the VCs build up their total Capital Under Management.
  • Naturally, the success of Fund 1 will be a factor in attracting capital for Fund 2.
Food for thought for the entrepreneur
Does Your Plan Fit the Needs of the Venture Capital Fund?
  • Venture Capitalists need big returns on winners in order to make profit overall - considering high ratio of losers and fee structure.
  • If your product or venture can justify these returns and you need lots of capital to achieve your Plan, VC may be the way to go.
  • If you are able to grow your company organically relying on revenues instead of capital, you may be better off grow a successful company without scaling to the size that will interest Venture Capital.
Are You Ready For Venture Capital?
  • The Compensation and Return arrangements in a VC Fund drives a certain type of behavior. 
  • While technically a form of 'patient capital,' Venture Capitalists typically have a relatively short time frame to achieve success. A fund will typically want to show some “Winners” early on in order to raise capital for the Next Fund.
  • You have to be ready to move quickly, there will not be much time to recover from errors in the plan or execution.
Are You Prepared to Become a Minority Stockholder?
  • In order to generate returns for the fund, VCs will usually obtain a significant percentage of the company over time - leaving the entrepreneur with a minority stake.
  • Having a small piece of a Big Pie can make you rich but you have to be mentally prepared with the loss of control associated with becoming a Minority Stockholder.
Other considerations
  • Experienced Venture Capitalists can provide valuable advice and guidance or connect you with their vast network of potential customers and acquirers.
  • Understand the Fund Life Cycle. Ideally, you want to catch a Fund during its initial investment phase.
  • Talk to Portfolio Company CEOs and see how their experience has been with the VC.
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