How Venture Capital Firms Work

How a Venture Capital Firm is Created

A group of smart people get together and decide that they would like to raise a venture fund to make investments in promising companies. In order to attract investment capital, they reach out to and pitch Limited Partners (LPs) who commit large sums of capital to the fund. They believe that the newly minted venture capital firm will make smart bets on promising young companies which will create a huge return on their investment.

A Limited Window to Invest

The venture capital firm typically has between 7 - 10 years in which to invest their LP's money into a startup, grow that startup, and sell the startup to another company or take it public (the exit). In the grand scheme of growing companies, that isn't a lot of time.

Therefore the newly created fund needs to find opportunities relatively quickly toward the inception of the fund, put that capital to work, and then spend the rest of their time trying to make sure those investments become big exits.

Balancing Equity

The only type of deal that works for these venture funds is to take an equity stake in the startup's company, which hopefully they can sell later when it becomes wildly successful. Venture Capitalists get paid on a percentage of the profits they generate for their LP's, so if there isn't a big sale, they only get a pre-determined salary, which usually isn’t terribly small either.

The entrepreneur and the Venture Capitalist are in a constant struggle between giving up enough equity to make the entrepreneur still feel happy and taking enough equity to earn the venture capital fund enough profit to return to its Limited Partners.

Go BIG or Go Home

With such a short window of opportunity to make a financial return, venture capital firms need to invest in particular markets where there is the greatest opportunity for a massive exit. Therefore, industries like technology and healthcare, which can take a small idea and turn it into a huge opportunity quickly, tend to be their focus. Other industries such as retail, consulting, and real estate, tend to be less attractive because they cannot produce exponential returns quickly.

Remember that a venture fund needs to make huge bets in order to get huge returns. Therefore they must start by finding companies that have huge exit potential and then reserve enough cash and manpower to support them through their growth.

Lots of Failure

The cold hard reality is that most of these investments, even after a tremendous amount of screening and support, are simply going to fail. When an investment fails, the money that was invested tends to go with it, meaning the venture fund has to absorb massive losses in its tenure. To account for this massive failure, the venture capitalist must hope that at least one of their investments will be such a big hit that it will make up for all of the failures.

What this Means for You

The very nature of a venture capital fund explains exactly what the entrepreneur should expect when pitching their business.

First, that the venture capital investor is certainly going to look for deals that fit within high growth, high exit industries like technology and healthcare.

Second, the venture capitalist is going to want a healthy equity stake in the business in order to provide enough proceeds in an exit to make up for all of their losses. “Healthy” is a relative term, but it’s usually more than 10% and less than 50%.

The third is that the venture fund is going to need to invest in a business that has the opportunity to generate a massive return in a short period of time. A business that just throws off a healthy profit each year does nothing for them in the time frame they have allotted.

The last, and this may be the most important, is that the venture capital fund can only have one outcome with your company after they have made their investment - either sell it or take it public. Either way once that money goes in the company, it is on a single path toward liquidity.