Venture capital firms are very important in the world of startups, so it’s vital for startup founders to understand how they work and their potential benefits.
Knowing what VC firms are and how they work can help you decide whether or not VC funding is right for you and your business.
What Are Venture Capital Firms?
A venture capital firm is a type of private equity fund that’s structured as a limited partnership. Essentially, investors can put their money into a joint fund for investing in early-stage companies, and each person who contributes to the fund is designated as a limited partner.
A single partner manages venture capital funds, called the general partner, and decides what companies to invest the fund in, based on specific criteria.
In other words, the general partner essentially puts the limited partners’ money to work for them, with little effort needed on their part.
VC fund investment criteria may include things like growth and liquidity benchmarks, market position, uniqueness of the product or service, and strength of the company’s management team.
Many venture capital funds focus on investing in specific sectors or industries. For example, there are clean energy, health care, and IT funds.
When venture capital funds get invested, they take a minority share of equity in return.
They then aim to grow the value of this equity and profit by selling it to another company (through an acquisition) or by taking the company they invested in public (through an IPO) and selling their shares on the market.
When a venture capital fund makes a return on an investment, the profit is split between all the limited partners, and the general partner earns a management fee in addition to a share of the profit.
What Is the VC Firm Investment Process?
Before venture capitalist firms even meet with a startup’s founders, they generally conduct some pre-screening process to select proposals that meet their VC company’s standards.
Startup founders and early-stage business owners seeking venture capital funding have to fill out an application and provide a variety of information about their company for pre-selection.
For example, they have to send information about their product or service, business model, management team, and any revenue they are already generating.
Basically, anything that shows their company has potential for growth and profit and meets certain criteria can help land a meeting with VC investors.
After VC firms select successful applicants, they schedule meetings with the founders or co-founders to review their business plans and hear their pitch. This is when startup founders have a chance to share their pitch decks with investors in person.
If the meeting goes well, the venture capitalists then do further due diligence and look closely at all aspects of the company, including the team’s background and financials, to ensure everything checks out and that they are not being misled in any way.
The investors will also do a deep dive into the industry to look at competitors and the current market to better understand growth and profit potential.
After that, VC firms move on to negotiating their investments. They’ll start by offering a certain sum of money in exchange for a certain percentage of equity. The company’s leadership might then make a counteroffer if they don’t like the terms of the initial deal proposed.
Once the venture capitalists and startup founders agree on a deal, they draw up and sign all the required legal documents to make the partnership official.
The legal paperwork includes all the details of the deal, including the amount and terms of the investment, the composition of the board of directors, exit plans, and what matters require the approval of the venture capitalists, such as asset sales and acquisitions.
The whole VC investment process can take up to three months or more, although many deals are closed in just two to eight weeks.
How Do Venture Capital Firms Make Money?
As discussed above, venture capital firms make money in two main ways: by collecting management and performance fees.
VC firms collect management fees no matter the investment outcome, which is usually about 2% to 2.5% of the total funds they manage. These management fees are typically collected annually and cover operation costs and other expenses.
VC performance fees are calculated as a percentage of the profits from profitable investments. Venture capital firms usually collect 20% of the profits for funds that surpass predefined performance benchmarks.
This business model of venture capital firms is often referred to as the 2-and-20 rule.
-min.webp)
