Critics quip that the only thing venture capitalists (VCs) are good at is making money for themselves. While General Partners (GPs) earn fees, they provide expertise in sourcing, structuring, and managing investments.
The economics of the venture business is such that the total fees paid to VCs are a small percentage of the total amount of money invested. In most cases, management fees are 2% of the total fund size per year, with 20% of profits paid out as carried interest.
The Money Flow—Management Fees
The typical VC firm receives funding from LPs through a commitment to a fund. LPs pay three types of fees:
- Fund expenses for fund organization, administration, and legal fees
- Fund management
- Carried interest
The firm invests LP’s money in companies and receives carried interest (a.k.a. "carry") on the returns. The carried interest is how VCs make the majority of their money.
VCs are paid for years of experience and expertise in finding, assessing, and investing in companies. They are also paid for their time and effort in managing the investments and working with the portfolio companies.
In reality, most VCs are not in it for the base fees. They are in it for the carried interest. And they can only generate carried interest if they create substantial returns for their LPs.
Fund expenses for organization and administration typically include thousands of dollars in attorney fees and ongoing legal fees regulated to negotiations and documents. The management fee typically ranges from 2% to 2.5% of committed capital and is charged annually.
Meanwhile, carried interest is typically 20% of profits, which means that the GP receives 20% of profits from an investment after the principal is returned to the LPs.
The Money Flow—For Startups
The typical startup receives funding from VCs as an equity investment. The VCs then own a percentage of the company and are paid back through the sale of the company or an initial public offering (IPO).
VCs invest in a company as early as the seed stage when the company is just getting started and is often pre-revenue. The VCs provide the funding that allows the company to build its product, hire its team and start generating revenue. That said, VCs also invest in the pre-public stage.
The amount of money VCs invest in a company varies, but it typically ends up with the VCs owning half the business. Most seed rounds today range from $1 million to $4 million. The median Series A round is about $10 million, the median Series B is $27 million, and the median Series C is $35 million, following a pullback in average valuations since 2021.
The key thing to remember is that VCs are not investing in a company indefinitely. They are looking to exit their investment within five to seven years.
So, where does all the money go in a venture investment? Most of it goes into building the infrastructure required to grow the business. This includes expenses investments in things like manufacturing, marketing, and sales, as well as in the balance sheet, like providing fixed assets and working capital. In other words, VCs invest in a company's ability to scale.
The bottom line is that venture capital is a high-risk, high-reward business. VCs are investing other people's money to make a big return. And while they get paid for their work, most of their earnings come from making successful investments.
The Lifecycle of a Venture Investment
Venture investments typically go through three stages:
- In the early stage, when the VC firm provides the seed funding to get the company off the ground;
- The growth stage when the company is scaling and needs additional capital to support its growth; and
- The exit stage when the company is sold or goes public.
The early stage is the riskiest, as there is often little to no revenue, and the company may not even have a product yet. The growth stage is less risky, as the company has revenue and is starting to scale. The exit stage is the least risky, as the company is proven and has a track record.
VCs typically invest in several companies at each stage to diversify their risk. They also want to see some companies succeed to offset the losses from the ones that don't make it.
VCs are looking for companies that will generate high returns. They are willing to take on more risk in the early stage to potentially earn higher returns later on. The rule of thumb is that among 10 startups a VC invests in, three to four will fail, another three or four will return the original investment, and one or two will generate handsome returns.
At the fund level, the goal is to significantly outperform public markets, to the tune of 5-15 percentage points above the performance of a broad-based market index during the same period. This is because of the risks of venture investing, including high fees, long holding periods, and illiquidity. The top-quartile venture funds achieve this outperformance, with an average annual return ranging from 15% to 27%.
The best-performing VCs tend to be sector-focused, with deep knowledge of their target industries. They are also often serial entrepreneurs who have founded companies themselves and have first-hand experience with the challenges of startup life.
What separates the top performers from the also-rans is not just returns but also how those returns are achieved. The best VCs take a patient and hands-on approach, working closely with their portfolio companies to help them overcome challenges and achieve their full potential.
So if you're looking to start a company, or are already running one, seek out the VCs with the best track records. They may not always be the flashiest or most well-known, but they're the ones who will help you turn a good idea into a great business.
Chris Sacca's first fund, the "Lowercase Fund," famously returned 250x to investors. His key to success? Investing early in companies like Twitter, Instagram, and Uber. Sacca's secret sauce is his focus on consumer Internet companies. That focus has allowed him to achieve superior returns by picking the right companies and getting in on the ground floor.
To take advantage of these top-tier actively managed funds, you typically have high minimums, often $500,000 or more. For the average individual, you need at least $13 million to invest since even small endowments have dozens of fund managers with an average of 36 fund investments.
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