How Venture Capital Works: A Beginners Guide

f you’re a startup founder looking to extend your runway, you have various options to choose from in terms of financing. And one of the most well-known options is, of course, venture capital. 

If you decide to go the VC route, however, it’s super important that you have a good understanding of how VC funds are structured and how VCs function so you can be sure your business model fits into what VCs are looking for.

Overall, the VC deal structure and business model can be very complex, but this article will shed some light on the basics, including a breakdown of how VC investing is structured, key terms, and provisions that exist within the VC business model.

Understanding Venture Capital: Key Terms

In order to raise venture capital, you MUST understand how VC funds operate. When pitching to investors, there are a couple of key terms to understand when it comes to a venture fund structure.

Venture Fund

A VC fund is a sum of money, or capital, that is used as the main investment vehicle for investing in startups. This capital, often referred to as “dry powder,” is meant to be deployed into startups. 

Each fund is structured as a limited partnership governed by partnership agreement contracts usually over the span of 7-10 years. 

The goal of the fund throughout that time period is singular: make money. Venture funds make money through 2 ways:

1. Carried interest on the fund’s return (about 20%)

2. Management fee (usually about 2%)

Management Company

The management company, or VC firm, conducts the actual business of the venture fund. It is not the same as the venture fund. The management company is the operations and people behind the fund. It serves as the business entity that is created by the firms’ general partners. 

The management company uses the management fee it receives to pay overhead related to the venture firm’s operations such as rent, salaries of employees etc. Management companies receive the management fee to help deploy and grow their funds. 

VC managers make carried interest only after the Limited Partners have been paid.

General Partner (GP)

A GP is the partner of the management company. Another way to define GP is someone who manages/oversees the venture fund. GP can be a partner at a large VC firm or an individual investor. 

GP’s raise and manage venture funds, make investment decisions, analyze potential deals, hire on behalf of the fund, help their portfolio companies exit, and make the final call on what to do with the money they manage. Overall, a GP’s role narrows down to two key responsibilities: investing capital in high-quality companies and raising future capital.

GPs are paid from carried interest and management fees. For example, if carried interest is 20%, this means that 20% of a funds profits will be paid to the GP. 

Limited Partners (LPs)

Where does the actual capital for a venture fund come from? This is where Limited Partners come in. They are the money behind the venture fund. Typically, LPs are institutional investors such as:

• University endowments
• Pension funds
• Sovereign funds
• Insurance companies
• Foundations
• Family offices
• High net worth individuals

Portfolio Companies (Startups)

The bread and butter of the venture fund structure is of course the portfolio companies. These startups receive financing from the venture fund in exchange for shares of preferred equity.

It depends on the individual fund, but to receive VC financing, portfolio companies must meet certain standards or requirements. Things like:

• They should operate in a large market
• Have product market fit
• Have a great product that customers love
• They must show promising economics and the ability to create a sizeable return for their investors

And if there is an M&A or IPO event, the fund can convert its shares to cash and make a profit.

Types of VC Funds

VC funds develop their portfolio based on a specific investing strategy. There are three investment fund types that VC firms may structure their portfolio on, which include:

1. Stage - early, mid or late
2. Geography – focus on companies based on a specific region location
3. Sector – biotech, IT, retail, etc.

How to Structure a VC Deal

Now that you have an overview of the VC fund structure, we can dive into the structure of VC deals. Most VC firms follow a business model that includes investing in several startups at once with the expectation that the returns from one startup will compensate for the losses of the other portfolio companies. 

As a result, the VC environment can be volatile in terms of returns. As such, the VC deal structure has several provisions in place that allows VC firms to protect themselves from potential downsides. 

Here is an example of a typical deal structure:

In this scenario, the VC fund invested $5M in exchange for 30% of preferred equity. 

Example of Downside Provisions:

• Liquidation preference – gives the VC firm absolute preference over common shareholder until their $5M is returned (like how creditors receive preference)
• Disproportionate voting rights – enables the VC firm to direct the startup’s strategy (i.e. decisions around later rounds of fundraising, capital investments, etc.)
• Anti-dilution clauses (‘ratchets’) – ensures the equity share of the VC firm is not diluted, regardless of how later rounds of financing turn out

Example of Upside Provisions:

• option to acquire a pre-agreed number of shares in the future at a pre-agreed price, enabling the Venture Capital firm to acquire more stock at a discount if the startup does well (even if other VC firms come along and offer much higher amounts for the equity)
• Exit strategy assurance – a clause that determines when the startup has to liquidate its share

Example of General Common Provisions

• right to elect the majority of the directors to the startup’s board - enables the VC firm to maintain control over management of its day-to-day

• rights to access all of the startup’s internal documents (i.e. financial statements, documents relation to all transactions, etc.)

The Reality of Venture Investing

VC’s filter through thousands of deals each year and select the most promising startups to invest in. Among those startups who are venture-backed companies, only a small percent actually make it to an exit event. Below are some statistics of the percentage of companies that exit:

• 3 % of companies exit above $100 million
• 0.7 % exit above $500 million
• 0.2 % exit above $1 billion
• 0.06 % exit above $2 billion

Each fund is typically active for 3-4 years but has a lifetime of about 10 years. A portion of the fund is reserved for follow on investments to support existing portfolio companies and a portion for future investments. 

The unfortunate reality is that over 70% of startups fail and that fundraising with VCs can be a mysterious, difficult process. However, ultimately it is important to remember that VCs are structured to serve as an ally, partner and mentor to the entrepreneur. Everybody wins!

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