How A Venture Capital Fund Works, And Why It Changes Who It Backs
Fees, carry, fund life and the math of returning a fund explain most investor behavior that founders find puzzling. A plain guide to the machine behind the check.
A venture capitalist who passes on a profitable, growing company is not necessarily being irrational. They may simply be doing what their fund structure tells them to do. Understanding that structure explains a great deal about which pitches get funded and why.
Venture capital is not the partners’ own money in most cases. It is a pool raised from outside investors with a fixed life, a fee arrangement and a promise to return capital with a profit. Almost every investor decision traces back to those three facts.
LPs, GPs and the fund itself
A venture fund is usually organized as a limited partnership. The limited partners, or LPs, supply most of the capital. They are typically institutions such as pension funds, university endowments, foundations, insurance companies, funds of funds and family offices, along with wealthy individuals. Under federal securities rules, private funds generally sell only to investors who meet accredited or similar qualified standards.
The general partner, or GP, manages the fund and makes the investment decisions. The partners whose names you see on the website usually work through a management company that is paid a fee by the fund.
How the people running the fund get paid
The traditional arrangement is summarized as two and twenty. The management fee, conventionally around 2 percent of committed capital a year during the main investment period, pays salaries, offices and operations. Fees often step down later in the fund’s life. Actual terms vary by firm and are set in the fund’s partnership agreement.
The real prize is carried interest, conventionally around 20 percent of the fund’s profits, paid after LPs have received their capital back and, in many funds, a preferred return. Carry is what aligns the GP with the LPs: the partners make serious money only if the fund produces serious gains.
Why every check is sized for a home run
Venture returns tend to follow a power law. A small number of investments generate most of a fund’s returns, while many return little or nothing. A fund therefore needs each investment to have a credible path to an outcome large enough to matter at the level of the whole fund.
The math is simple to run yourself. If a fund owns a tenth of a company when it is sold, the sale has to be ten times the size of the fund for that one investment to return the fund. A larger fund needs larger outcomes. This is why an excellent business that might sell for a modest sum can be a poor fit for a big fund, and a reasonable fit for an angel, a smaller fund or no outside money at all.
Funds also set ownership targets. Many aim to own a meaningful percentage of each company they back so that a successful exit moves the needle for the whole fund. That target explains why some investors push for a larger allocation than the founder planned to sell, and why a firm may pass on a round where it cannot get the ownership it needs.
Time, reserves and the clock you cannot see
Most venture funds are built to last roughly ten years, often with options to extend. New investments are usually made during the first several years. After that, the remaining capital goes into follow-on investments in existing portfolio companies, and the fund focuses on getting its winners to a sale or listing.
Funds hold reserves, a portion of capital set aside for those follow-on rounds. How much a fund has reserved for your company, and how far into its life it is, affects whether it can support you later. A fund near the end of its investment period may be enthusiastic but unable to lead your next round.
Partner time is a constraint too. Each partner can sit on only so many boards and support only so many companies closely. When a partner says they are at capacity, that is often a literal description of their calendar, not a polite rejection.
What to ask a VC before you take the money
Ask which fund the check is coming from, how large it is and roughly how far into its life it is. These are normal questions and good investors answer them.
Ask how they think about reserves and whether they typically participate in follow-on rounds. A clear answer tells you whether they will be in the room when you need support.
Ask what kind of outcome they need to see for an investment like yours to work for the fund. If their honest answer is far beyond what you believe your business can become, that is useful information for both sides. The best fit is a fund whose math works with the company you are actually building.
This is general information, not financial advice. Nothing here is a recommendation to buy or sell anything; speak to a licensed adviser about your own position.
