What Are Venture Capital Funds?
Let me explain venture capital funds directly: they pool money from investors to take equity stakes in promising startups, offering high-risk but potentially high-return opportunities. These funds don't just provide essential capital; they also guide young companies toward growth, with the end goal of profiting through strategic exits, such as IPOs or acquisitions.
Key Takeaways
- Venture capital funds are investment pools focused on high-risk, high-return opportunities in startups and innovative small to medium enterprises.
- These funds provide significant funding and guidance, aiming for substantial returns through exits like IPOs or acquisitions.
- Typically reserved for 'accredited investors,' venture capital investments involve illiquidity, long horizons, and substantial risk.
- A standard fee structure in venture capital is 'two and twenty,' meaning 2% management fees and 20% of the profits.
- Venture capitalists play an active role in the companies they invest in, often participating in management and strategic decisions.
How Venture Capital Funds Operate and Create Value
Venture capital is a type of equity financing that allows entrepreneurial or other small companies to raise funding before they have begun operations or started earning revenues or profits. You should know that venture capital funds are private equity investment vehicles that seek to invest in firms with high-risk/high-return profiles, based on a company's size, assets, and stage of product development.
Unlike mutual and hedge funds, venture capital funds specialize in early-stage investments. The firms they back have high-growth potential but are also risky with a long investment horizon. Venture capital funds take a more active role in their investments by providing guidance and often holding a board seat. Therefore, VC funds play an active and hands-on role in the management and operations of the companies in their portfolio.
Venture capital funds have portfolio returns that tend to resemble a barbell approach to investing. Many of these funds make small bets on a wide variety of young startups, believing that at least one will achieve high growth and reward the fund with a comparatively large payout at the end. This allows the fund to mitigate the risk that some investments will fold.
Key Functions and Operations of Venture Capital Funds
Venture capital can be seed, early-stage, or expansion financing based on the business's maturity. However, regardless of the investment stage, all venture capital funds operate and are regulated in much the same way.
Venture capital funds, like all pooled funds, must raise money from investors before investing. A prospectus is given to potential investors of the fund who then commit money to that fund. All potential investors who make a commitment are called by the fund's operators, and individual investment amounts are finalized.
From there, the venture capital fund seeks private equity investments that have the potential of generating large positive returns for its investors. This normally means the fund's manager or managers review hundreds of business plans in search of potentially high-growth companies. Fund managers base investment decisions on the prospectus mandates and investor expectations.
After an investment is made, the fund charges an annual management fee, usually around 2% of assets under management (AUM), but some funds may not charge a fee except as a percentage of returns earned. The management fees help pay for the salaries and expenses of the general partner. Sometimes, fees for large funds may only be charged on invested capital or decline after a certain number of years.
Analyzing Venture Capital Fund Returns
Investors earn returns when a portfolio company exits through an IPO or a merger/acquisition. Two and twenty (or '2 and 20') is a common fee arrangement that is standard in venture capital and private equity. The 'two' means 2% of AUM, and 'twenty' refers to the standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark. If a profit is made off the exit, the fund also keeps a percentage of the profits—typically around 20%—in addition to the annual management fee.
Though the expected return varies based on industry and risk profile, venture capital funds typically aim for a gross internal rate of return around 30%.
Types of Venture Capital Firms and Their Investment Strategies
Venture capitalists and venture capital firms fund several different types of businesses, from dotcom companies to biotech and peer-to-peer finance companies. They generally open up a fund, take in money from high-net-worth individuals, companies seeking alternative investment exposure, and other venture funds, then invest that money into a number of smaller startups known as the VC fund's portfolio companies.
Venture capital funds are raising more money than ever before. According to financial data and software company PitchBook, the venture capital industry invested a record $136.5 billion in American startups by the end of 2019. The total number of venture capital deals for the year totaled nearly 11,000—an all-time high, PitchBook reported. Two recent deals included a $1.3 billion investment round into Epic Games, as well as Instacart's $871.0 million Series F. Pitchbook also cited an increase in the size of funds, with the median fund size rounding out to about $82 million, while 11 funds closed out the year with $1 billion in commitments including those from Tiger Global, Bessemer Partners, and GGV.
The Bottom Line
Venture Capital (VC) Funds are essential for providing early-stage companies with the capital and guidance they need for growth. These funds pool investments from sophisticated investors, focusing on high-risk/high-return opportunities in startups and emerging firms. Unlike mutual and hedge funds, VC funds actively engage in the management of their portfolio companies. Returns are realized when these companies exit through IPOs or acquisitions.
You should understand the high-risk nature and long investment horizon typical of VC funds, along with the standard management and performance fees associated with them. As the industry continues to evolve, more capital is being poured into VC funds, indicating strong confidence in the high-growth potential of the startups they back.
Other articles for you
Liquidity ratios assess a company's ability to pay short-term debts using liquid assets.
Transfer payments are government-distributed funds to individuals without requiring goods or services in return, aimed at wealth redistribution and economic support.
Exchange-traded notes (ETNs) are debt securities issued by financial institutions that track market indexes without paying interest, trading like stocks on exchanges.
A dividend policy is a company's strategy for distributing earnings to shareholders, outlining payout frequency, timing, and amounts.
Position trading involves buying and holding investments long-term to capitalize on trends until they peak.
A cash-out refinance lets you convert home equity into cash by replacing your existing mortgage with a larger one.
Form 1099-R is an IRS form for reporting distributions from retirement accounts to ensure proper tax handling.
Time value is the part of an option's premium that reflects the time left until expiration, influencing its overall extrinsic value.
Per capita is a term used to express averages per person in a population, commonly applied in economics for metrics like GDP and income.
Net operating income (NOI) measures the profitability of income-producing real estate by subtracting operating expenses from revenue.