Venture Capitalist

How a venture capitalist works

A venture capitalist manages other people's money inside a fixed legal structure, and almost every behavior founders find puzzling follows from that structure.

The fund is a limited partnership. Outside investors are limited partners and supply nearly all the capital. The venture capitalists control the general partner entity, which manages the fund, makes investment decisions, and carries the liability. Alongside it sits a management company that employs the team and receives the management fee. The partnership has a stated life, commonly ten years with extension options, split into an investment period when new positions are made and a harvest period when the portfolio is managed toward exits.

Capital is committed rather than delivered. Limited partners sign for a commitment, and the general partner draws it down through capital calls as investments and expenses arise. Uncalled commitments are dry powder.

Compensation has two parts, and they pull in different directions.

Management fee = fee rate x committed capital during the investment period, then typically a reduced rate on invested cost afterwards

Carried interest = carry percentage x (proceeds distributed above the return of contributed capital and any preferred return)

ILPA's fund terms survey reports that a 20 percent carried interest rate remains the norm, appearing in 71 percent of funds sampled, and that management fee rates have remained stable in a 1.5 to 2.0 percent band. The same survey reports that a preferred return hurdle of 8 percent is the standard where one exists, that most waterfalls compute the hurdle on a compounded basis, and that 16 percent of sampled funds have no hurdle at all. Venture funds sit disproportionately in that last group: many have no preferred return, so carry begins once contributed capital has been returned.

There is also a regulatory definition worth knowing, because it explains what a venture fund is allowed to do. Under the Investment Advisers Act rule that exempts advisers to venture capital funds from registration, a venture capital fund must hold no more than 20 percent of aggregate capital contributions and uncalled committed capital in assets other than qualifying investments and short-term holdings, must not incur borrowings or other leverage above 15 percent of aggregate contributions and uncalled commitments and then only for a non-renewable term of 120 days or less, and must not issue securities giving holders redemption rights except in extraordinary circumstances. A venture capitalist therefore cannot run a levered strategy or offer liquidity on demand the way a hedge fund can.

The investment model is shaped by skew rather than averages. A venture portfolio is built on the expectation that most positions return little and a small number return a multiple of the entire fund. Two practical consequences follow. First, the venture capitalist has to believe every new position could plausibly return the fund, which rules out businesses that are good but bounded. Second, reserves matter as much as entry checks, because the right to put more money into the one working company is worth more than avoiding a loss in a failing one.

Day to day, the work divides into sourcing, diligence, winning the allocation, board and portfolio support, and fundraising the next fund. The last is not optional: a firm that cannot raise a successor fund stops being a venture firm regardless of how the current portfolio performs, which is why realized distributions matter so much.

Worked example

Suppose a first-time manager raises a $100,000,000 fund with a ten-year term, a 2 percent management fee during a five-year investment period and 2 percent of invested cost thereafter, 20 percent carried interest, no preferred return, and a whole-of-fund waterfall. All figures are hypothetical.

Step one: how much is actually invested. Fees during the five-year investment period run 2 percent of $100,000,000, or $2,000,000 a year, so $10,000,000. Fees in years six through ten, charged on remaining invested cost, might total another $6,000,000. Add $1,500,000 of fund expenses over the life. That leaves roughly $82,500,000 of investable capital out of a $100,000,000 fund.

Step two: portfolio construction. Suppose the manager targets 25 initial positions averaging $2,000,000, which is $50,000,000, and holds $32,500,000 in reserves for follow-ons, about 0.65 dollars of reserve per dollar of initial check.

Step three: the gross return needed. To return 3x the fund net of fees to limited partners, the portfolio must generate enough gross proceeds to cover $100,000,000 of contributed capital, the carried interest, and the $300,000,000 net. Solving roughly: if gross proceeds are G, limited partners receive $100,000,000 plus 80 percent of the profit above it, so 100 + 0.8 x (G - 100) = 300, which gives G = $350,000,000. The general partner's carry is 20 percent of $250,000,000, or $50,000,000, spread across the partnership over a decade.

Step four: where $350,000,000 comes from. Assume a typical skew. Fifteen positions return nothing. Six return 1x their invested capital. Three return 5x. One returns 40x. If the single outlier had $8,000,000 invested across entry and follow-ons, it alone returns $320,000,000. The three 5x positions with $6,000,000 each return $90,000,000. The six 1x positions return their $12,000,000. Total is $422,000,000, comfortably above the target, and the result was decided entirely by the one position.

Step five: the counterfactual. Remove the outlier and the same fund returns $102,000,000 gross, which after fees is roughly break-even for limited partners and produces no carried interest at all. The distance between a top-quartile venture fund and a mediocre one is usually one or two positions, which is why venture capitalists resist selling early and insist on reserves and pro rata rights.

Where it shows up

In the limited partnership agreement, the venture capitalist appears as the general partner. The agreement sets the management fee rate and basis, the carried interest percentage, any preferred return, the distribution waterfall, the clawback that returns overpaid carry at the end of fund life, the key person provision that suspends the investment period if named partners stop devoting substantially all their time to the fund, and the general partner commitment of the managers' own money. ILPA's Principles describe the whole-of-fund waterfall, in which all contributed capital and any preferred return are returned before carry is paid, as best practice, and note that it reduces reliance on clawback.

In regulatory filings, the firm appears on Form ADV, which every SEC-registered adviser and every exempt reporting adviser files and which is public. Advisers with at least $150 million in private fund assets under management also report on Form PF. The SEC aggregates both into its quarterly Private Fund Statistics, which is why fund counts and gross asset totals by strategy are publicly observable even though individual fund performance is not.

In the term sheet, the venture capitalist is named as the lead investor, with the round size, price, board composition, protective provisions and investor rights that follow. The NVCA publishes the model documents that most United States priced rounds are built from: the certificate of incorporation, stock purchase agreement, investors' rights agreement, voting agreement and right of first refusal and co-sale agreement.

In quarterly reporting to limited partners, the venture capitalist produces a capital account statement, a schedule of investments and the performance multiples, prepared in the format of the ILPA Reporting Template where a fund has adopted it.

In the portfolio company's minute book, the venture capitalist appears as a designated director elected under the voting agreement, subject to the same fiduciary duties as any other director, which is the source of most conflicts of interest that arise between a fund's interests and a company's.

Common mistakes

Reading a venture capitalist's behavior as personal preference rather than fund mechanics. A partner who will not lead a $1,500,000 round at a $100,000,000 fund is usually constrained by ownership targets and portfolio count, not by an opinion of the company.

Assuming the partner decides alone. Most firms require an investment committee vote, and many have a formal or informal unanimity norm among partners. The partner in the room is a sponsor, not the decision.

Confusing the management fee with profit. The fee funds salaries, rent, audit, legal and travel for a team over a decade, and it reduces the capital available to invest, which is why limited partners scrutinize it.

Believing carried interest is paid as deals exit. Under a whole-of-fund waterfall it is not paid until contributed capital, and any preferred return, has been returned. Under a deal-by-deal waterfall it can be paid earlier, which is precisely why clawback provisions exist.

Treating fund size as a measure of quality. Fund size sets the required exit size: a $1,000,000,000 fund needs outcomes an order of magnitude larger than a $50,000,000 fund for the same multiple, which changes which companies it can back.

Ignoring vintage. A fund's performance is compared against others of the same vintage year because deployment conditions differ so much across periods. A manager who looks strong against the wrong cohort is not being measured.

Related terms

A venture capitalist operates through the general partner entity and is funded by the fund's limited partners; the economics are the management fee and carried interest, tested against a hurdle rate where one exists. The activity itself is venture capital, and the individual analogue is the angel investor. The measures a venture capitalist is judged on are DPI, TVPI and IRR, and the reason early numbers look bad is the J-curve.

Frequently asked questions

What does a venture capitalist actually do?

Raises a fund from limited partners, sources and evaluates private companies, negotiates and prices investments, sits on boards or observes them, decides where reserve capital goes, manages the portfolio toward exits, distributes proceeds, and raises the next fund. In a small firm one person does all of it; in a large firm these are distinct roles.

How do venture capitalists get paid?

Two ways. A management fee, charged annually on committed capital during the investment period and usually on a reduced basis afterwards, which pays salaries and running costs. And carried interest, a share of the fund's profits, most commonly 20 percent according to ILPA's survey of fund terms, paid only after the fund has returned contributed capital and any preferred return to limited partners.

What is the difference between a venture capitalist and an angel investor?

The source of the money and the accountability that comes with it. An angel invests personal capital and answers to nobody. A venture capitalist invests a fund's capital, owes fiduciary and reporting duties to limited partners, is constrained by fund size and portfolio construction, and has to produce realized distributions to raise a successor fund.

Do venture capitalists use debt?

Not at the fund's investment level, and not much. The rule that exempts advisers to venture capital funds from SEC registration caps borrowing and other leverage at 15 percent of aggregate capital contributions and uncalled commitments, for a non-renewable term of 120 days or less. Funds do commonly use a subscription credit facility for short-term bridging of capital calls within those limits, and portfolio companies may take venture debt of their own.

Why does a venture capitalist want such a large exit?

Because the fund's return is decided by its largest positions. A fund needs each new investment to be capable of returning a meaningful fraction of the whole fund, so an outcome that would be excellent for a founder personally can be irrelevant to a large fund's result. Matching fund size to realistic outcome size is the single most useful thing a founder can check before taking a meeting.

How many companies does one venture capitalist back?

It varies with fund size and strategy, but an individual partner typically leads a small number of new positions a year and carries a board load they can actually service. A concentrated fund may hold twenty to thirty positions in total; a seed fund running an index-style strategy may hold well over a hundred, with correspondingly less involvement in each.

Related tools and reading

• SAFE Calculator
• Carry Calculator
• VC Salaries
• PitchBook Alternatives and Pricing