What are Venture Capital Funds?
Venture capital funds are pooled investment funds that manage the money of investors who seek private equity stakes in startups and small- to medium-sized enterprises with strong growth potential. These investments are generally characterized as very high-risk/high-return opportunities.
In the past, venture capital (VC) investments were only accessible to professional venture capitalists, but now accredited investors have a greater ability to take part in venture capital investments. Still, VC funds remain largely out of reach to ordinary investors.
Key Takeaways
- Venture capital funds manage pooled investments in high-growth opportunities in startups and other early-stage firms.
- Hedge funds target high-growth firms that are also quite risky. As a result, these are only available to sophisticated investors that can handle losses, along with illiquidity and long investment horizons
- Venture capital funds are used as seed money or "venture capital" by new firms seeking accelerated growth, often in high-tech or emerging industries.
- Investors in a VC fund will earn a return when a portfolio company exits, either through an IPO, merger, or acquisition.
Understanding Venture Capital Funds
Venture capital (VC) is a type of equity financing that gives entrepreneurial or other small companies the ability to raise funding before they have begun operations or started earning revenues or profits. Venture capital funds are private equity investment vehicles that seek to invest in firms that have high-risk/high-return profiles, based on a company's size, assets, and stage of product development.
Venture capital funds differ fundamentally from mutual funds and hedge funds in that they focus on a very specific type of early-stage investment. All firms that receive venture capital investments have high-growth potential, are risky, and have a long investment horizon. Venture capital funds take a more active role in their investments by providing guidance and often holding a board seat. VC funds, therefore, play an active and hands-on role in the management and operations of the companies in their portfolio.
Venture capital funds have portfolio returns that tend to resemble a barbell approach to investing. Many of these funds make small bets on a wide variety of young startups, believing that at least one will achieve high growth and reward the fund with a comparatively large payout at the end. This allows the fund to mitigate the risk that some investments will fold.
Operating a Venture Capital Fund
Venture capital investments are considered either seed capital, early-stage capital, or expansion-stage financing, depending on the maturity of the business at the time of the investment. However, regardless of the investment stage, all venture capital funds operate and are regulated in much the same way.
Like all pooled investment funds, venture capital funds must raise money from outside investors prior to making any investments of their own. A prospectus is given to potential investors of the fund who then commit money to that fund. All potential investors who make a commitment are called by the fund's operators, and individual investment amounts are finalized.
From there, the venture capital fund seeks private equity investments that have the potential of generating large positive returns for its investors. This normally means the fund's manager or managers review hundreds of business plans in search of potentially high-growth companies. The fund managers make investment decisions based on the prospectus' mandates and the expectations of the fund's investors. After an investment is made, the fund charges an annual management fee, usually around 2% of assets under management (AUM), but some funds may not charge a fee except as a percentage of returns earned. The management fees help pay for the salaries and expenses of the general partner. Sometimes, fees for large funds may only be charged on invested capital or decline after a certain number of years.
Venture Capital Fund Returns
Investors of a venture capital fund make returns when a portfolio company exits, either in an IPO or a merger and acquisition. Two and twenty (or "2 and 20") is a common fee arrangement that is standard in venture capital and private equity. The "two" means 2% ofAUM, and "twenty" refers to the standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark. If a profit is made off the exit, the fund also keeps a percentage of the profits—typically around 20%—in addition to the annual management fee.
Though the expected return varies based on industry and risk profile, venture capital funds typically aim for a gross internal rate of return around 30%.
Venture Capital Firms and Funds
Venture capitalists and venture capital firms fund several different types of businesses, from dotcom companies to biotech and peer-to-peer finance companies. They generally open up a fund, take in money from high-net-worth individuals, companies seeking alternative investments exposure, and other venture funds, then invest that money into a number of smaller startups known as the VC fund's portfolio companies.
Venture capital funds are raising more money than ever before. According to financial data and software company PitchBook, the venture capital industry invested a record $136.5 billion in American startups by the end of 2019. The total number of venture capital deals for the year totaled nearly 11,000—an all-time high, PitchBook reported. Two recent deals included a $1.3 billioninvestment round into Epic Games, as well as Instacart's$871.0 millionSeries F. Pitchbook also cited an increase in the size of funds, with the median fund size rounding out to about $82 million, while 11 funds closed out the year with $1 billion in commitments including those from Tiger Global, Bessemer Partners, and GGV.
FAQs
What are Venture Capital Funds? Venture capital funds are pooled investment funds that manage the money of investors who seek private equity stakes in startups and small- to medium-sized enterprises with strong growth potential. These investments are generally characterized as very high-risk/high-return opportunities.
What is venture capital easily explained? ›
Venture capital (VC) is a form of investment for early-stage, innovative businesses with strong growth potential. Venture capital provides finance and operational expertise for entrepreneurs and start-up companies, typically, although not exclusively, in technology-based sectors such as ICT, life sciences or fintech.
What is the meaning of venture capital funds? ›
A venture capital (VC) fund is a sum of money investors commit for investment in early-stage companies. The investors who supply the fund with money are designated as limited partners. The person who manages the fund is called the general partner.
What is venture capital answer in one sentence? ›
Venture capital is money that is invested in projects that have a high risk of failure, but that will bring large profits if they are successful.
How are venture capital funds structured and how do they make money? ›
Venture capitalists make money in two ways. The first is a management fee for managing the firm's capital. The second is carried interest on the fund's return on investment, generally referred to as the “carry.” Management fees.
How does a venture capital fund work? ›
Venture Capital Firms and Funds
They generally open up a fund, take in money from high-net-worth individuals, companies seeking alternative investments exposure, and other venture funds, then invest that money into a number of smaller startups known as the VC fund's portfolio companies.
What is venture capitalist in layman terms? ›
A venture capitalist (VC) is an investor who provides young companies with capital in exchange for equity. Startups often turn to VCs for funding to scale and commercialize their products.
What is venture capital with example? ›
Venture capital (VC) is a form of private equity and a type of financing for startup companies and small businesses with long-term growth potential. Venture capital generally comes from investors, investment banks, and financial institutions. Venture capital can also be provided as technical or managerial expertise.
What is the benefit of venture capital fund? ›
They can provide valuable business expertise and connections to help a startup grow and succeed. Venture capitalists typically provide long-term support to their portfolio companies. This support can include additional funding, guidance, and access to a network of resources.
What is the difference between venture capital and investment funds? ›
The first and primary difference between venture capital and investment banking is that venture capital firms typically invest directly into companies, while investment banks tend to serve as intermediaries in various financial transactions.
Endowments - Where Many VCs Get Their Money
Endowments are typically the big private universities, although public university systems, like the University of California system, have a big endowment, as well. Yale, Harvard, MIT, Stanford, Northwestern, are some of the biggest endowments out there.
What is a real life example of venture capital? ›
Examples of Venture Capital
Series A, B, C, etc.: These are multiple rounds of funding that a company goes through, generally getting more substantial as the business grows. For instance, Facebook's Series A was $12.7 million from Accel Partners, while its Series B ballooned to $27.5 million from various investors.
How much money is in venture capital? ›
2021 set a new record for venture capital investments in the United States. In 2021, the value of venture capital investments in the U.S. amounted to approximately 345 billion U.S. dollars, nearly twice as much as the previous year.
How do venture capital funds pay out? ›
In most funds, distributions are divided using a standard 80-and-20 arrangement in which, following a return of capital contributions to LPs, the LPs of the fund split 80% of the returns according to their ownership stake in the fund and the general partner (GP) takes home 20% of the returns in the form of carried ...
How do investors make money? ›
Some pay income in the form of interest or dividends, while others offer the potential for capital appreciation. Still, others offer tax advantages in addition to current income or capital gains. All of these factors together comprise the total return of an investment. Internal Revenue Service.
How do venture partners get paid? ›
Venture Partners are normally compensated with carried interest, versus receiving a salary. Carried interest or carry is generated from the fund performance, and it aligns incentives well, since Venture Partners only get compensated when the fund has positive returns.
What is venture capital for beginners? ›
For beginners, the first step is to gain a thorough understanding of the VC ecosystem. This means familiarizing oneself with the different stages of funding (seed, early-stage, late-stage), and the roles of the various players involved, such as venture capitalists, angel investors, and entrepreneurs.
What is venture capital explained for kids? ›
Venture capital is a type of private equity capital.. Typically it is provided by outside investors to new businesses that promise to grow fast. Venture capital investments are usually high risk, but offer the potential for above-average returns.
What does venture capital mean a short term? ›
A short-term capital provided to industries. A long-term start-up capital provided to new entrepreneurs. Funds provided to industries at times of incurring losses. Funds provided for replacement and renovation of industries.
What clearly defines venture capital? ›
Venture capital (V.C.) is a kind of financing that investors give to startups that are believed to have long-term growth potential. The investment can come from rich, banks, and other financial institutions. But, it does not always take a monetary form. It can also come in the form of technical or managerial expertise.
