How are VC firms structured?
A venture capital firm consists of general partners who form a VC limited partnership fund. They then raise money from wealthy individuals, private and public pension funds, educational endowments, insurance companies and sometimes operating companies, the limited partners.
Typical Venture Capital Fund Lifecycle
A venture capital fund typically has a 10 year lifecycle as detailed below:
- Years 1 to 4 initial investments made
- Years 2 to 6 follow-on investments in portfolio companies
- Years 4 to 10 harvesting or “cashing out” of investments
- At the end of the 10th year, the partnership dissolves and assets distributed to partners
Somewhere in the middle of the fund’s life after the bulk of the initial investment is made and perhaps some cash is taken off the table from the early ‘winners’, the general partners may start to raise an additional fund, recycling some of the investment success money and adding new limited partner investors.
Many experts recommend that entrepreneurs focus on funds in the initial investment phase as opposed to funds that are in their eighth or ninth year.
How are venture capitalists compensated?
Venture capital compensation varies but generally:
- General partners receive a management fee 1% -2.5% of fund’s assets. This fee is used to run the operations of the general partners including rent, salaries and other operating expenses.
- They also share in the upside created by their investments. Generally, they receive 20% of returns above some threshold agreed upon with their limited partners. So for example, if the venture capital firm sets the return of the Nasdaq stock market as their benchmark and the Nasdaq returns 10%, the venture capitalist would receive 20% of any return above the benchmark return, e.g. 10% in this case.
- In venture capital and limited partner investing circles, this type of fee structure is referred to as 2/20% or “two and twenty”.
Is There a Typical VC Operating Model?
Ben Horowitz of Andreessen Horowitz, a prominent venture capital firm in Silcon Valley notes venture capitalists developed an operating model that is still broadly used today:
- Raise a large amount of capital from institutional investors
- Assemble a set of experienced partners who can provide hands-on expertise in building the product and then the company
- Evaluate each deal very carefully with extensive due diligence and broad partner consensus
- Employ strong governance to protect the large amount of capital deployed in each deal. This includes requisite board seats and complex deal terms including the ability to control subsequent financings
- Manage own resources effectively by calculating the amount of capital/number of partners/maximum number of board seats per partner to derive the minimum amount of capital that must be invested in each deal