How does a VC firm work?

The goal of this article is not to explore in-depth the mechanisms of the VC model but rather to explain concisely how a VC firm works. This post is mainly intended at people whose aim is to enter the VC world or are just interested in understanding this model.

What is a Venture Capital (VC) firm?

A VC firm is a partnership of people (the Partners) who raise money (a fund) that they invest in startups (against equity) in order to make a return on investment further down the line.

Where does a VC firm get its money from?

A VC firm collects money from various sources such as high net worth individuals, family offices (investment firms of wealthy families), government funds, corporate funds, pension funds, etc. These entities are often called LPs, for “Limited Partners”, once they provide money to a VC firm.

How does a VC firm invest the money it has raised?

Once a VC firm has finished raising a fund, it needs to spend its money. There is no rule on how fast a firm should deploy its capital, how many companies it should invest in and at which frequency (invest in five companies per year? Twenty companies per year?). It all depends on the fund size (investing a $500M fund is not the same as investing a micro $10M fund) and the strategy of the VC firm (investing in early-stage companies versus late stage, investing small amounts vs investing big amounts…).

In terms of process, at a macro level, a VC firm generates what we call a dealflow, the “flow” of startups looking to raise money, and if from this dealflow investors find promising startups they want to invest in, they will give the founders money against equity (shares) in their company. 

How does a VC firm make money?

We should distinguish two aspects here.

First, a VC firm needs money to run its operations. Basically to pay the salaries of the employees, various expenses (travel, office…) as well as all the legal costs. To do so, they generally take what we call a “management fee”. For example on a $100M fund, if the management fee is a 2% annual fee, the VC firm will take $2M every year (until the fund is spent) just to cover the bills.

Obviously the LPs don’t provide money to a VC firm so that it can take a management fee only. If LPs contribute to a fund, it’s because they expect a return on their investment. How does that work?

As we’ve seen in the previous question, when VCs invest in a startup, they basically give money against shares of the company. Ideally, the value of a company increases over time as the company raises more money, increases its revenue, gets more customers, etc. As a consequence, the stake owned by the investors also increases its value and once an “exit” happens – mainly when startups go public (IPO) or get acquired by bigger companies (M&A) – investors sell their shares at a higher price than what they bought them for (and hence make a profit).

The profit is then shared between the VC firm and its LPs and is structured around a hurdle rate and a carry. Let’s say that the hurdle rate is at 10%, the carry is 20% and that the VC firm delivered a 15% profit. Then it means that the first 10% of the profit will integrally go to the LPs and above this 10 %, the VC firm will take 20% (the carried interest) of the remaining profit (here 20% of the 5% remaining).

It’s the business model of a VC firm. If they don’t hit the hurdle rate, the investors will make no money in carried interest.

What happens once a VC firm has invested all its funds and runs out of money?

Once a VC firm has completely deployed a given fund, it needs to raise another one. This is why you often see a number next to the name of a fund (for example Sequoia Growth Fund VIII).

If a VC firm is successful, it will have no problem raising successive funds with its existing LPs (and with new ones). If it’s not the case, they won’t be able to raise more money and as a consequence will become zombie firms and eventually die.

What does the life cycle of a fund look like?

It might take a year or two to raise a fund, two to five years to deploy it, and between seven to ten years before you see the first exits. So, no, the VC model is not a get-rich-quick scheme. Even quite the opposite when you know that the majority of VC firms out do not return a profit.