I keep getting hundreds of E-mails asking me to clarify – “ How Venture Capital Works “ and “ How Do Venture Capitalists Make Money “. So decided to write a blog post on the working of a venture capital firm in a condensed form.
Understanding of “How Do Venture Capitalists Make Money ” is quite easy. Limited Partners(LPs) invest in VC (Venture Capitalist) firms. They are termed VC funds. The VC Fund is then invested in startups that have a huge potential of bringing in massive returns. VC firms charge management fees for the funds invested by Limited Partners(LPs). The management fees would be around 2 to 2.5 percent of the total funds invested. The management fees are utilized for the daily operations of the VC firm ( like paying employees, support staff, office rent etc.) including salaries of VC partners.
[ Important Note: If you are unable to understand few technical jargons here, you might have to read this article – Roles Inside The Venture Capital Firm ]
But, this is not how the VC partners nor the LPs really make big money. The money invested in VC Firms by LPs are in turn invested on early or late stage startups (call it portfolio companies) for a period of 7 to 8 years expecting huge returns ( either through a buyout or merger & acquisition or an IPO). Once the company generates huge returns(either through aforementioned ways), the VC funds typically get their carried interest in the capital gains. The carried interest is normally between 20 and 25 percent of the total capital gains.
For example, let us assume, the LPs have invested a sum of $100 million in the VC firm. We will call it VC Funds. These funds have been invested in an early stage startup. Out of this fund, $2 million (2 percent of VC fund) is claimed by the VC firm as a management fee. This fee is utilized as said earlier for the daily operations of the VC firm ( like paying employees, support staff, office rent etc.) including salaries of VC partners. Now, let us assume the startup company has reached its IPO and has the investment fund has returned three times the capital ($100 million), which is $300 million, say, over a period of 8 years. Out of $300 million, the VC partners get 20 percent as their carried interest. That is, $60 million (2 percent of $300 million) will be received by VC Partners as their carried interest. This answers your question “How Do Venture Capitalists Make Money”.
As startups are a risky business investment (data says, 9 out of 10 startups fail), VCs will love to invest only in those companies that can potentially give them 10 times return on investment so that they can cope up with the losses of other portfolio companies. This is also the reason why landing a Venture Capital is very tough. If your startup has got invested by a VC its a sign of progress and stamp of approval for your startup product/service. Because Venture Capitalists do not invest without a thorough research.
Hope you enjoyed reading the blog post with loads of insights. Feel free to comment below your opinions.
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