Venture capital (VC) funds are ever-present in the startup ecosystem, for obvious reasons: founders and their companies often need large amounts of capital in a short amount of time in order to generate the kind of scalable growth that allows them to be competitive. While most founders know in a general sense that VCs stand to profit from their investments, we don’t often think about exactly how this is accomplished. This article covers the main ways in which VC funds make money, and how it might impact your approach to seeking and accepting investment.
Capital Appreciation: The basis for a VCs investment is that it will (hopefully) increase in value over time. A VC fund typically invests in at least a few companies at a time, and will often group them together according to similar traits under the management of individually separate funds. A VC fund’s collection of companies is called a portfolio. When a VC fund makes an investment in a company, it purchases shares of stock which, ideally, increase in value over time. In a perfect world, all companies in a portfolio will perform well and increase in value because the product or service they produce will be in high demand. If this happens, the company could experience one of the below events:
Initial Public Offerings (IPOs): This is probably the most commonly recognized scenario. In an IPO, a company’s shares of stock are listed on a public exchange, like NASDAQ or the New York Stock Exchange, and may be purchased by the general public. This can be a huge boost in investment for the company, and allows VCs to make money by allowing them to sell their shares (after the expiration of any lock-up period) on a secondary market.
Mergers and Acquisitions (M&A): Less commonly recognized but more likely, especially for companies which experience moderately successful growth, is a merger or acquisition with or by another company. The company which is making the merger or acquisition is typically larger and more established, and sees the target startup as beneficial to long-term growth.
Secondary Sales: In limited circumstances, VC funds can also sell their shares to other investors through secondary sales, although this is usually made difficult by restrictions placed on the shares, such as lack of transferability and required holding periods.
Dividends and Distributions: Some VC funds may receive dividends or distributions from their portfolio companies. This occurs when the invested companies generate profits and distribute a portion of those profits to their shareholders, including the VC fund. However, dividends are less common in early-stage investments, where companies often reinvest profits for growth.
Management Fees and Carried Interest: VC funds charge (i) management fees to cover their operational expenses and (ii) carried interest (often called “carry”) and generate profits for the fund managers. Management fees are typically a percentage of the amount of money invested by the fund’s limited partners and are charged annually. Carry is a share of the profits earned by the fund and is typically a percentage of the profits after the return of capital to the limited partners.
What does this mean for Founders?
The most important consideration is also the most obvious, which is that VCs want to invest in a company which has a strong founding team with good credentials; a product which is either very likely or even demonstrated to have success in its target market; and a clear path to exit. The more successful a company is, the more likely it is it will be acquired or have some other kind of exit, at which point the well-positioned stakeholders will profit. VCs need to demonstrate to their limited partners that they can make wise investments with their money, and a track record of successful exits is the best way to do that.
The second consideration is that, with few exceptions, VCs who specialize in pre-seed funding also are probably not contributing large enough amounts of capital to carry a company through its expected runway. That means founders will have to convince a larger number of investors – at least at the very early stages of the company’s lifecycle – to invest, and continue doing so until the company has a proven record of growth (eg, sales and / or customer acquisition).
Lastly, VCs are in the business of investing in extremely high-risk enterprises. That risk can be somewhat mitigated if the VCs bring expertise to the company they’ve invested in, usually in the form of a person who sits on the board of directors and represents the VCs – often called a “preferred director”. Preferred directors can be helpful in that they often bring with them a wealth of expertise in the industry of the company in which they’ve invested. That said, keep in mind that the board of directors is the primary driver of strategic direction in a startup, so it’s a good idea to make sure any VCs which get involved in management of the company are aligned with the founders when discussing strategy and vision.
This article is for informational purposes only, and may not be considered legal advice.
Bob Baker is a founding partner of Peak Corporate Counsel. He has worked with numerous founders on a variety of issues specific to startups. When he’s not advising innovators, he can be found at networking events, playing rugby, or hiking with his kids.