How Venture Capital Works | Mark MacLeod

September 6, 2023 - Mark MacLeod

How Venture Capital Works

Do you understand how venture capital works?

Understanding how VC funds work is a crucial first step in learning how to raise venture capital effectively.

Venture Capital Case Study: How VC Works

Here’s a case study to illustrate how VC works:

Let’s take a $100M fund, called Acme Ventures. $100M is pretty small for VC funds these days, but it’s an easy number.

The number of investments Acme makes will depend on the stage it invests in. A fund of this size likely plays in the seed to series A game.

Let’s say that Acme plans to make 10 or more seed-stage investments of $1M – $2M each. It also plans to double down on half of those investments at the series A stage with up to $5M allocations.

Any excess funds goto the expenses of running the fund + other investments.

VC Management Fees and Carried Interest Explained

Fund managers make money in two ways:

Management fees

Carried interest

Venture Partner Roles and Returns

Management fees: A fund manager typically charges 2% per year to run the fund. A $100M fund generates management fees of $ 2M per year. This goes to pay salaries, travel expenses, rent, etc.

Carried interest: As the fund generates exits, it must first return the capital. Then, the partners running the fund split the profits. 80/20. 80% for the investors (Limited Partners) and 20% for the people making the investments. They are the General Partners.

Let’s say that over the life of Acme Ventures it generates total returns of $300M. It invested $100M and returns $300M.

$100M of that returns the capital invested. $200M is the return on that capital.

80% ($160M) goes to the Limited Partners. 20% ($40M) goes to the General Partners.

Now, not all investments work. In fact, most don’t. If Acme Ventures makes 12 investments, they might break down as follows:

2 home runs

2 doubles

3 singles

5 failures

What this means is that the vast majority of the $300M in total returns end up coming from the two home runs.

This is a simple illustration. It skips many things such as hurdle rates. But it works for our purposes. From this illustration you can understand what matters to a VC.

Decoding VC: Venture Capital Advantages and Disadvantages

Here’s what you need to know from this simple example so that you can better understand what drives VCs.

Most VCs are well paid. A $100M fund would have 2 -3 General Partners. There will be other staff and other expenses, but the bulk of the $2M in management fees will goto these 2 – 3 people.

Carried interest is where the real money is: Those same 2 – 3 partners will split the bulk of the carried interest. $40M across three people goes far!

Outliers only: If that $40M in carried interest comes from only 2 deals, then every deal must have that home run potential.

This is key and is why most companies that pitch VC get rejected.

Let’s say $250M of the $300M comes from two deals. Acme owns 15% of each company. Those two sales alone have to be worth $ 1.67 billion for Acme to get $ 250M.

$ 1.67B * 15% = $250M.

It is so rare for exits to happen at this level.

Bear in mind, this is what it takes for a small fund. Imagine the bar for the bigger funds you are pitching.

VCs, especially in top-tier firms are hunting for outliers. They only want companies that have home-run potential. They only want founders with home-run ambition.

Along the way, if it looks like your company is not on that trajectory, your VCs may focus on their other investments. It’s not personal. It’s because they need home runs to make their funds work.

If you want to raise VC for your business, this is what you are signing up for. You need to want to build to a home run outcome.

Photo by SpaceX on Unsplash

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