Explain Venture Capital to Me

These days the topic surrounding financial markets has piqued public interest more than it ever has before. Many are asking if the recent surge in excitement is signaling the end of a bull market, and for some of us, these questions are frustrating to listen to. Maybe we are approaching the end of a bull market, or maybe we aren’t. and maybe it isn’t. However, the point is whenever the public takes a widespread interest in understanding a topic, society is always better off because it typically comes with increased education and pressure for transparency.

In this article, we’re bringing light to a particular space within the financial markets — Venture Capital. For first-time startup founders and the broader public, venture capital is a bit of a mystery, even though it has such a large impact on emerging companies and the financial market.

High-Level View

Before getting into the details, it’s important you know and understand a few key pieces of information.

1. Financial intermediary: A financial intermediary takes investors’ money and invests it directly for them.
2. VCs only trade in private companies (companies that can not be traded on public markets or invested in by non-accredited investors).

• They invest and help companies in their portfolio
• Abnormal returns through IPO or acquisition
• Funds the internal growth of the company

Fund Structure

Here’s how venture capital funds are structured. Let’s start with some terminology.

Let’s say a fund performs really well, how do GPs and LPs know who gets paid what amount? This is where the famous “2 & 20” structure comes in. What does this mean?

2% = carried interest, this means that VC get 2% of committed capital in the form of management fees

Example: Let’s say you are starting a fund where you managed to raise $100MM in committed capital from your LPs. With a 2% management fee structure, you can expect that you will earn $2MM just for managing the funds.

Now, let’s say that your fund performs well and realizes 300% gains at the end of 10 years, which is the typical life of a venture fund. You would have returned:

So now that the fund has a $294MM profit, how do we know who gets what portion?

Typically, this is agreed upon ahead of time. A traditional agreement looks as follows:

1. All of the original capital invested goes back to the LPs, plus interest (also known as a hurdle rate)
2. Then the remaining is divided between GPs and LPs, 20% and 80% respectively.

But wait, if you invest in a private company who do you sell your shares to see the actual returns?

Great Question.

Venture capitalists realize gains one of two ways:

• Strategic buyer: Selling the startup to a larger company
• IPO: Bringing the company to the public markets

So all I have to do is invest in a startup and look for someone to buy it or just bring it public? Sounds easy.

Incorrect.

There are billions and billions of people with ideas for a startup. Millions and millions of startups and only 1% of successful startups. Choosing the right ones is hard.

So if you are looking to start your own venture fund, it’s necessary to have a deep-rooted network within technology or startup hubs and a list of very good frameworks to evaluate good startup ideas from bad ones.