Understanding the motivations and operations of VC funds is critical to getting funded

What is “venture capital”? Seems like a basic question every founder should be able to answer in their sleep.

And yet, talking with founders, I hear many misconceptions. Mostly what I hear, though, is a vague understanding that venture capitalists are people who write checks to fund startups. Which is true, but it’s the details of why they write checks, how they write checks, and what they do after they write those checks that matter.

Understanding how venture capital works is the foundation to finding the right partner (or any financial partner) for your startup, and using that relationship to its greatest advantage.

What Venture Is, and What It’s Not

Let’s start with what venture capital is not. First and foremost, it is not a charity. It is not philanthropic capital. Nor is it a government grant. It is not friends and family who are investing to support you, or who think the technology is cool, or want to help find a solution to cancer or climate change. It’s not a bunch of rich people with money to burn supporting interesting startups.

Put this way, everyone says, yes of course, but then fails to understand the implications. Venture capital is investment. It’s high risk, (hopefully) high return investment.

Venture capital in the general sense is any entity that invests in startups for financial return. This includes not only venture capital funds but angels and angel groups, corporate venture capital, accelerators, and occasionally (but not very often) family offices.

The big money in the venture world is obviously the VC funds run by VC firms. These are in short, investment businesses. Where mutual funds invest in public stocks, private equity firms invest in established businesses, hedge funds invest in arbitrage opportunities, and REITs invest in real estate, venture capital funds invest in startups for one reason and one reason only — to make money. By making money for their clients, they make money for themselves.

Never forget that in the end, their jobs are not to support your startup but to make money for their investors. Sometimes their incentives are aligned with yours to make your startup successful; sometimes they are in conflict. So understand who you’re partnering with and what their end goals are.

VC Firms and VC Funds

Venture Capital firms, like a16z, Khosla, and Sequoia, are businesses, with regular employees. They are usually structured as LLCs. Estimates vary, but there are somewhere around 5,000 VC firms operating around the world.

These VC firms set up Venture Capital funds structured as Limited Partnerships. These are the pools of capital for investment. A new VC firm will start with a single fund, then after 3–5 years when the fund is fully invested, open a 2nd fund. Most VC firms are investing from a single fund at any time, though giants like Khosla Ventures may have multiple funds focusing on different stages or sectors.

Where Does VC Money Come From?

Like the startups they invest in, the first job of VC firms is to find investors. Investors in the fund are called LPs (limited partners), while the managers from the VC firm are known as GPs (general partners).

In other words, Venture Firms are businesses that invest other people’s money. Who are those LPs? Typical investors include:

  • Pension funds
  • Life insurance companies
  • University endowments
  • Family offices and high net worth individuals
  • Sovereign wealth funds (governments)
  • Corporations

These investors all have one thing in common — money available for long-term investment. Most of their investment pool goes into public equities and government and corporate bonds, but a small percentage, usually under 5%, may be put into “alternative investments” — higher risk investments that offer the potential for higher returns along with diversification, including private equity, hedge funds, and venture capital.

Startup investing is difficult. It takes a lot of time and specialized knowledge to attract and evaluate deal flow and even more to do proper due diligence on the candidates. The high failure rate and power law returns mean a portfolio of investments is required to turn startup finance from gambling into investment.

So rather than trying to invest in startups themselves, even sophisticated organizations are content to pay venture firms to do the investing for them.

How VCs Make Money — the 2 and 20

The standard, almost universal way venture firms make money from their funds is known as 2 and 20.

The 2 is a yearly 2% management fee paid by the fund to the venture firm. On a $100M fund, that’s $2M per year. The management fee covers the cost of operating the fund and running the venture firm: employee salaries, legal and accounting, outside consultants for diligence, insurance, office rent, conferences, etc.

The 20 is a 20% carried interest (usually shortened to “carry”)—a cut of the investment winnings that goes to the GPs. It’s a kind of success fee. If a fund invests $1M in a startup that generates a $100M return, the GPs keep $20M and distribute $80M to the LPs (though all principal is usually returned to LPs before the 20% carry kicks in.)

There’s a few implications of this 2 and 20 structure that are important to understand.

First, bigger is better. A $1B fund generates $20M per year in fees, which allows them to hire a lot more people than a $100M fund and pay themselves higher salaries. Microfunds are challenging. A $10M fund only collects $200K per year in fees. That barely covers legal and accounting costs without a single full-time employee.

Second, venture firms make money whether their investments fail or succeed. But it’s basically break even. The real income comes from the carry when an investment hits the jackpot. Some GPs have become billionaires from the carry on a few successes.

Third, investors have to make a return after fees are paid. Over 10 years, the 2% fees eat up 20% of the fund. A $100M fund only has $80M to invest. And a 10x return to the fund is an 8x return to LPs.

Fund Lifetime — 3 and 10

Unlike stock funds, venture funds are designed as closed-end funds with a fixed lifetime, traditionally 10 years.

The fund usually invests over the first 3 years, then has seven years to harvest the investments before shutting down at year 10. More funds are starting to set 12-year lifetimes and sometimes longer, but because the LPs have to pay a 2% management fee every year the fund continues, a 10-year life remains the standard.

This fund lifetime is why VCs look for investments that can reach an exit, ideally within 5 years and no more than 7 years. All investments have to be liquidated before the fund can be closed. As the fund nears the 10 year limit, VCs put increasing pressure on the founders to find an exit for the company, even if it isn’t ideal.

Once the fund is fully invested, it can no longer make new investments. Many funds will reserve some percentage of its capital for follow-on investments in later rounds of the portfolio companies.

After the fund is closed for new investments, the VC firm begins fundraising for its next fund. The key to finding investors in the 2nd fund is the success of the 1st fund’s portfolio. While there are unlikely to be any big exits yet, showing growth on paper in the valuation of the portfolio companies is critical for the firm.

Nearing the 10 year mark, the firm is opening its 3rd fund. The ability to find LPs this time will be based mostly on the cash returns from the 1st fund. Having a big success in the portfolio is indispensable if the firm’s owners and employees want to keep their jobs.

AUM, Stage, and Check Sizes

The size of the fund is referred to as AUM — Assets Under Management. AUM can range from a $2M microfund to a massive fund of $10B or more.

Though funds may claim to invest over a wide range such as from Pre-seed to Series B, or write checks from $500K to $20M, in most cases, the AUM limits their smallest and largest checks, and therefore the stage at which the fund can reasonably expect to invest.

Though there are exceptions, most funds invest in 20 to 30 startups each. Less than 20 and there’s too much risk of not having a big winner in the portfolio. More than 30 investments in 3 years spreads the team too thin.

Divide the AUM by the portfolio size and you’ll get the average check size. A $100M fund making 25 investments has an average check size of $4M. Anything less than $1M doesn’t move the needle, even if they get a 100x return. Anything more than $10M would put too many eggs in one basket.

So that $100M AUM fund, no matter what they claim, is probably writing $1M to $10M checks, with $1M to $5M initially, and up to $10M in a follow-on round for the one company in the portfolio that is looking like the biggest winner.

Those size checks make it hard to invest in pre-seed, but ideal for seed and Series A, but too small for later rounds. In contrast, a $1B fund will be writing $10M to $100M checks, and therefore focusing on investments at Series A and later.

The Fund Thesis

With thousands of funds, how does an LP pick which fund to invest in? And how do founders know which ones might invest in them?

The answer is the thesis — the master plan for the fund. What will it invest in and why? Some funds focus on seed stage investing in AI startups, others in later stage investing in climatetech or robotics. One fund I’m an LP in only invests in YC portfolio companies, another only in chemistry and materials.

The thesis is the combination of what, where, and how much a fund intends to invest:

  • stage: what stage funding rounds will the fund invest in?
  • sector: does it specialize in a specific industry or technology?
  • geography: does it focus on startups in the US, EU, or perhaps Africa?
  • check size: what are the minimum and maximum sized checks the fund will write?
  • uniqueness: what makes this fund better than other similar funds?

The Venture Firm Team

The venture firm may not have many employees, but they do have a rigid hierarchy. When pitching people at venture firms, be sure to know who you’re talking to and their role in the investing process.

  • General Partners (also called Managing Partners): these are the apex creatures of the venture world. They’re the owners of the venture firm. They decide the fund’s thesis, and keep most of the carry. They are responsible for finding LPs and constitute most of the investment committee that makes the final investment decisions.
  • Principals: senior venture executives. They do most of the work in sourcing deals, running the diligence process, and presenting the startups to the investment committee. They will often take board positions and manage the relationship with portfolio companies.
  • Associates: mid-level members of the team, the associates work on sourcing deals, evaluating startups, and supporting the diligence process.
  • Analysts: the most junior members of the venture firm (excluding interns). They are tasked with deal screening, initial calls with founders, and industry outreach.
  • Support staff: the firm may have industry experts on staff to help evaluate technologies and work with portfolio companies, plus people responsible for financial, legal, and marketing activities.

Venture KPIs

A venture fund is only as good as the return it generates for their LPs. There are a number of different ways to describe those returns.

TVPI (Total Value to Paid-in): the total return on paper compared to how much has been invested. This is the total portfolio value (amount received for exited companies + current value of unexited companies) divided by the amount of capital paid into the fund (AUM).

MOIC (Multiple on invested capital): total value of investments divided by capital invested.

DPI (Distributions to Paid-in): the amount of cash returned to investors divided by the amount of capital paid into the fund (AUM)

IRR (internal rate of return): the annualized rate of return on the fund investment.

The TVPI is a good measure at an earlier stage when the value of the portfolio is (hopefully) growing but few companies have exited so far, so the returns are mostly on paper.

MOIC is similar to TVPI, but uses the amount of capital invested rather than the total amount of capital of the fund. Once the fund is fully invested, TVPI and MOIC will be the same.

The DPI is the best indicator of how much investors have actually received back in cash. This is the only important number in the end, but it may be 10 years or more before a final number is reached.

The IRR adds the critical time component to the returns to compare with more liquid investments like the S&P 500 index.

LP Co-Investing

Some LPs, especially corporations and family offices, use venture funds to do the work identifying investments in their sector of interest. Then they may co-invest alongside the fund with a direct investment in the startup.

Some VCs prohibit this practice where others encourage it. Especially for VCs that focus on a particular industry with investment from industry players, this network is symbiotic for venture fund, LP, and startups.

Imagine a fund that includes GM, Mercedes, and Toyota among its LPs that invests in new battery technologies. When a promising startup pitches, the fund managers can reach out to the LPs for validation on the technology. It can introduce the startups to LPs as potential customers. And those LPs might decide to make their own investments in the startups. For me, this is where venture capital is at its most valuable.

Pitching VCs for Investment

Big VCs get up to 20,000 applicants per year. They don’t have the capacity to look through all those applications seriously. Many VCs don’t even provide contact information. So how can you pitch them?

Ideally, they reach out to you. This is the benefit of a few top accelerators like YC. Even before demo day, the VCs are pawing through the cohort list reaching out to ones they find interesting. Industry-specific accelerators and pitch events are the best way to find investors who specialize in your niche. Trade shows and industry conferences can be another venue to meet investors.

But in most cases, it’s up to you to find a way to reach them. That usually means some kind of warm intro. Make a list of the 5–10 funds that seem like the ideal fit for your startup. Then take advantage of your board members, existing investors, advisors, and even customers to introduce you to the GPs and principals there.