Venture Capital

How venture capital works

Venture capital is a way of financing companies that cannot be financed any other way. A business with predictable cash flows can borrow. A business with tangible assets can pledge them. A three-person company with a product that does not yet exist has neither, so the only financing available is one that accepts a total loss on most positions in exchange for a share of the upside on a few.

The structure that makes this possible is a closed-end limited partnership with a fixed life. Limited partners, typically endowments, foundations, public and corporate pension plans, insurers, sovereign funds, funds of funds and family offices, sign commitments. The general partner draws those commitments down over an investment period, buys minority equity positions, holds them for years, and distributes proceeds as companies are sold or listed. The partnership then winds up, usually after ten years plus extensions.

The strategy runs on skew, not averages. Returns in a venture portfolio are concentrated: most positions return little or nothing and a small number return a multiple of the fund. Three rules follow.

• Every new investment must be capable of returning a meaningful fraction of the fund on its own. A business that will realistically reach a $50,000,000 exit is not investable for a $500,000,000 fund even if it is a good business.
• Reserves are part of the strategy. A fund holds capital back so it can follow its winners in later rounds, which is why pro rata rights are negotiated so hard.
• Losses are bounded and gains are not. A position can lose 1x. It can return 100x. Portfolio construction is about buying enough chances at the second outcome.

Stages describe where in a company's life the money arrives, and they map to different risk and check sizes. Pre-seed and seed money buys a team and a first product, typically on a SAFE or convertible note or a small priced round. Series A buys evidence that the product has a market. Series B and C buy scale. Growth-stage rounds buy market position ahead of an exit. As stage rises, ownership per dollar falls and loss rates fall with it.

The instruments are standardized. Early money usually arrives through a SAFE or a convertible note, which defers pricing. Priced rounds buy convertible preferred stock, which carries a liquidation preference so preferred holders are paid before common in an exit, plus protective provisions, board rights, information rights, registration rights and a right of first offer on future issuances. The NVCA publishes the model documents that most United States rounds are drafted from.

The regulatory boundary is worth knowing because it constrains what a venture fund can do. The Investment Advisers Act rule defining a venture capital fund for exemption purposes requires that the fund represent itself as pursuing a venture capital strategy, hold no more than 20 percent of aggregate capital contributions and uncalled committed capital in assets other than qualifying investments and short-term holdings, incur no leverage above 15 percent of aggregate contributions and uncalled commitments and then only for a non-renewable term of 120 days or less, issue no securities granting redemption rights except in extraordinary circumstances, and be a private fund. Not every firm calling itself a venture fund meets these tests, but the tests explain why venture funds do not use acquisition debt and do not offer investors a way out mid-life.

Performance is measured with multiples and a rate of return rather than with periodic yields, because there are no periodic cash flows. Invest Europe's reporting guidelines define the three standard multiples on a net basis against paid-in capital: DPI, cumulative realized proceeds returned to investors relative to paid-in capital; RVPI, the current fair value of assets still held relative to paid-in capital; and TVPI, the sum of the two. Paid-in capital means committed capital that has actually been called, not total commitments.

Worked example

Suppose a fund raises $250,000,000 with a ten-year term, a five-year investment period, a 2 percent management fee and 20 percent carried interest. All figures are hypothetical.

Step one: investable capital. Fees of roughly $40,000,000 over the fund's life and $2,000,000 of expenses leave about $208,000,000 to invest.

Step two: portfolio. The fund makes 30 initial investments averaging $4,000,000, which is $120,000,000, and reserves $88,000,000 for follow-ons. Average entry ownership is 15 percent.

Step three: dilution. Each surviving company raises three more rounds, each diluting existing holders by about 20 percent. A 15 percent entry position becomes 15 x 0.8 x 0.8 x 0.8, which is 7.68 percent, before follow-on investment adds any of it back. Exercising pro rata in one of those rounds might hold the position nearer 9 or 10 percent.

Step four: outcomes. Assume 18 positions return nothing. Seven are acquired at prices that return the money invested in them, roughly $35,000,000 total. Four exit at $250,000,000 each; at 8 percent that is $20,000,000 each, so $80,000,000. One company goes public at a $4,000,000,000 valuation with the fund holding 7 percent, worth $280,000,000 at listing and, after lockup expiry and a decline, distributed for $240,000,000.

Step five: fund result. Gross proceeds are $35,000,000 plus $80,000,000 plus $240,000,000, which is $355,000,000 against $250,000,000 of paid-in capital. DPI is 355 divided by 250, or 1.42x, before carry. Limited partners receive contributed capital of $250,000,000 plus 80 percent of the $105,000,000 profit, which is $84,000,000, so $334,000,000 net, a net TVPI of about 1.34x. The general partner's carry is $21,000,000.

Step six: what a good result would have required. To reach a 3x net, gross proceeds would have to be $875,000,000, meaning the listed company alone would have needed to be worth several times more, or a second outcome of similar size would have to appear. The gap between a 1.3x fund and a 3x fund is one company, not thirty small improvements.

Where it shows up

In the fund's limited partnership agreement: fund term and extensions, investment period, the definition of a qualifying investment, the management fee and its step-down, carried interest, the distribution waterfall, clawback, key person and no-fault divorce provisions, and the general partner commitment. ILPA publishes principles that describe market-standard positions on these terms, including its preference for a whole-of-fund waterfall.

In quarterly limited partner reporting: a capital account statement, a schedule of investments with fair values, and the performance multiples. ILPA's Reporting Template standardizes the presentation of fees, expenses and offsets so limited partners can compare managers.

In the portfolio company's financing documents: the certificate of incorporation creating the preferred series and its liquidation preference and protective provisions, the stock purchase agreement, the investors' rights agreement carrying information rights, registration rights and the right of first offer, the voting agreement setting board composition, and the right of first refusal and co-sale agreement covering founder share transfers. The NVCA maintains and periodically updates all of these as model forms.

In public regulatory data: private fund advisers report on Form ADV, and those with at least $150 million of private fund assets under management also file Form PF. The SEC publishes aggregated Private Fund Statistics from both, which is where reliable counts of venture funds and their gross and net assets come from.

In benchmark reporting: Cambridge Associates builds private investment benchmarks from quarterly fund financial statements supplied by managers, and ranks funds within vintage year by internal rate of return and by multiples. That vintage-year grouping is standard practice because market conditions during a fund's deployment period dominate its result.

Common mistakes

Treating venture capital as a source of working capital. It is equity sold permanently in exchange for a claim on a future exit, and it comes with governance rights. A business that can grow on revenue or on debt usually keeps more of itself by doing so.

Assuming valuation is the term that matters. Liquidation preference, participation, board composition and protective provisions frequently determine more of a founder's outcome than headline price does, particularly in a modest exit.

Ignoring fund size when choosing an investor. A fund's size sets the outcome it needs. Taking money from a fund whose model requires a billion-dollar result when the honest plan is a $200,000,000 company creates a conflict that surfaces years later, usually when an acquisition offer arrives.

Confusing committed capital with available capital. Management fees and expenses are paid out of the fund, so a $100,000,000 fund invests meaningfully less than $100,000,000. Multiples are measured against paid-in capital, which includes those fees.

Reading early fund performance literally. Fees are charged from day one and marks lag, so a young fund shows negative returns almost by construction. That pattern is the J-curve, not a signal.

Assuming venture capital and private equity are the same thing with different names. Venture funds buy minority stakes in growing companies and, under the exemption rule, essentially cannot use leverage. Buyout funds acquire control and finance the purchase partly with debt on the target.

Related terms

Venture capital is practiced by a venture capitalist inside a fund whose economics are the management fee and carried interest and whose investors are limited partners. The stage ladder runs pre-seed, seed round, series A, series B, series C and growth equity. Fund results are reported as DPI, TVPI and IRR, shaped early by the J-curve. For how the asset class differs from buyouts, see venture capital vs private equity.

Frequently asked questions

What is venture capital in simple terms?

Money pooled from large institutional investors into a fund that buys small ownership stakes in young private companies, holds them for years, and makes its return when those companies are acquired or go public. The fund expects most of its investments to fail and relies on a few large successes to carry the whole portfolio.

Where does venture capital money come from?

From limited partners: university endowments, foundations, public and corporate pension plans, insurance companies, sovereign wealth funds, funds of funds, and wealthy families and individuals. The venture firm's own partners also commit their own money, the general partner commitment, so they share in losses as well as gains.

How is venture capital different from a bank loan?

A loan must be repaid on a schedule regardless of performance and is usually secured against assets or cash flows. Venture capital is never repaid; the investor owns a piece of the company and is paid only if the company is sold or listed. In exchange for that risk the investor takes governance rights and expects a return far above any interest rate.

What percentage of a company does a venture fund take?

It depends on stage and fund strategy rather than a fixed rule. Early priced rounds often sell a minority stake in the teens to low twenties as a percentage, and later rounds sell less for more money. What is consistent is that venture investors take minority positions and do not acquire control of the company.

How long does a venture fund last?

Commonly ten years from the final closing, with provisions for one or more extensions. New investments are made during an investment period of roughly the first five years, and the remainder of the life is spent supporting the portfolio and realizing exits. Limited partners cannot redeem in the meantime; venture funds generally grant no redemption rights except in extraordinary circumstances.

How is venture capital performance measured?

With multiples and a rate of return calculated against paid-in capital. DPI measures cash actually returned relative to capital called. RVPI measures the fair value of what is still held. TVPI is the sum of the two. Internal rate of return adds the timing of cash flows. Funds are compared within their vintage year, since deployment conditions differ sharply between periods.