venture capital funding
Venture capital (VC) firms invest money into new venture in exchange for equity. They make money during a liquidation event (when the new venture is bought or goes public). Companies raise VC funding to help hire new employees, build product, fund working capital, and generally fuel growth.
Venture Capital Firm Structure
VC firms are typically organized as limited partnerships, with two kinds of partners: limited partners and general partners. Limited partners are strictly investors in the VC firm and do not play any kind of management role. They provide the bulk of the capital available for the venture capital investors to invest. Limited partners are large institutions or very wealthy individuals we mentioned above. General partners actively manage the firm.
limited partners
VC firmss typically raise money from large institutions or very wealthy individuals. Large institutions that might invest in a VC fund include pension funds, large banks, insurance companies, investment management companies, university endowments, and large non-profit organizations. These investors in VC funds are looking for the possiblitty of high returns over a long period of time and diversification.
Firms versus Funds
VC firms raise capital into separate "Funds" and they deploy investments from these "Funds." So, for example, Kleiner Perkins, the VC firm, might raise a fund called Kleiner Perkins Fund VIII. Several years later, it might raise a nother fund called Kleiner Perkins Fund IX. It is tradition in the industy to use Roman Numerals to designate each fund. These funds become, in a sense, their own seperate investment businesses all managed by the parent company. Raising separate funds allow VC firms to constantly bring in new investors, manage different investors with different interests and timing requirements, and track performance by capital pools more easily. Funds are categorized, like bottles of wine, into vintage years. Vintage year refers to the year during which the fund started investing. So if Kleiner Perkins IX started investing in 2007, Kleiner Perkins IX has a 2007 vintage year.
investment behavior
Typical early-stage venture capital firms (as distinct from later-stage, growth equity, or private equity funds) might raise $25M-150M per fund. If they typically invest a total of $8M-$12M per company, this would imply that they will invest in roughly 10-20 companies per fund. If they raise another fund 3 years later, they may replicate these numbers again in that fund. If a typical VC firm has 3 active funds, they may be managing 30-60 investments.
Because VC funds invest in high-risk startups or new ventures, they experience a relatively high failure rate among investments. Roughly speaking if they invest in 10 companies, they might expect that 2-3 of those deals will fail. They typically expec that 5-6 of those companies will return their investment or make them a little money. This means that 7-9 companies will either fail or create a slight return. Because of this, VC firms rely on 1-3 companies returning a significant amount of capital--generally 5-10x or $50-$100M+ for each company.
Compensation Structure
VC firms receive two major types of compensation: management fee and carried interest (or "carry"). Management fee refers to an annual fee that is compensation for simply managing a pool of money on behalf of a set of investors. For the most part, VC firms receive this fee regardless of their performance as investors. This fee is typically 2%-2.5% of committed capital. So if a firm receives $200M in capital committments, it will generally receive $4M-$5M per year in management fee.
Carried interest refers to the share of profits that a VC firm receives. Most VC firms receive 20% of profits after repaying the amount of money they have raised plus interest plus management fee. So their investors, or limited partners, receive 80% of profits. If a VC firm raised $200M (with a 2% management fee) and managed the fund for 10 years, they would need to repay their investors $200M plus $40M (10 years of management fee at $4M / year) plus any accrued interest or preferred returns that the limited partners negotiated. In this case, we will assume that the interest or preferred returns are equal to $0. Now let's assume that after 10 years the VC firm has returned $440M by selling their equity stakes in companies. To see what carried interest the firm would receive we first need to subtract the principal plus accrued management fee, representing $240M. This leaves $200M in profits. At this point, the VC firm would get 20% or $40M and the investors would receive 80% or $160M.
The VC compensation model is often referred to as 2 and 20.
Learn more by reading How Investment Firms Work.
Motivation and timing of investor
VC firms are typically seeking long-term equity-based returns. VC firms recognize that it may take 5-10 years to realize a return. They are usually patient, active investors. They will take a significant role in shaping the outcome of the investment.
Typical Amount of Funding
VC funding can vary widely but is usually between $1M and $5M+ in their initial investment and $8M-$12M in total funding to the company. VC funds will often make an initial investment but they almost always reserve additional capital for future funding. They do this because most new ventures require more funding than originally anticipated.
Availability
VC funds exist all over the country but they are highly clustered in large technology centers. Nearly half of all funds and all VC investment occurs in California (especially the San Francisco area). Boston, New York, Texas, and Seattle also have relatively large, established venture capital markets. Smaller firms exist in other areas as well. The NVCA (National Venture Capital Association) is a good starting place to find VC firms in your area.
Interest and Principal Payments
VC firms do not provide debt financing so there are no interest and principal payments.
Equity
VCs will generally require that you provide them with an equity stake ranging from 20% to 50%.
Control
VC firms will require a significant amount of control While no one firm may control the company, as new venture raise more and more VC funding eventually VC firms as a group will own a controlling stake in the company. Even when they are minority investors in the company, they will invest in preferred stock with lots of control provisions and rights. They will take one or more board seats as well to help oversee their investment.
validation / Other
VC investment represents a significant validation of your business idea or concept.