Curious About How VCs Make Money? Come On, We’ll Tell You!
May 23, 2023
When you think of venture capitalists, you think of suave women and men, dressed sharply, carrying around a Starbucks and a LV bag with probably a laptop in it.
Their typical day would probably look like sitting around a conference table, evaluating businesses and swiping left and right on startups in real time. In short, venture capitalists elicit the idea of power, wealth and decision-making.
As a startup founder, learn what makes venture capitalists tick (yes, money!) It is important to understand how you can pitch to them better, secure the perfect deal you’re looking for and make it worthwhile for both you and them.
What Do Venture Capitalists Want?
Venture capitalists are typically looking to invest in startups that have a “boom” potential. In other words, they’re looking to make exponential returns. They like companies that have extremely high potential to grow.
They understand that not all companies that show promise will succeed. Even then, they want a company that at least shows the potential for a big return in the future.
Otherwise, what would be their impetus to invest? Venture capitalists are surely not philanthropists funding passion projects! You think Sequoia Capital would’ve poured $450 million into Web3 company Polygon if it didn’t believe that the company would ride the Web3 wave when it reemerged?
As a startup founder seeking a venture round, it is important for you to understand how you will provide them with this value. But more on that later. First, let’s understand how VCs make money.
How Do VCs Make Money?
Let’s start with an analogy. Imagine being a talent scout for a professional sports team. Your role would involve finding talented individuals who can become star players. You will have to evaluate thousands if not lakhs of athletes to find the right handful of people to coach.
Once you have found your future stars, you have to buy their contract, help them improve their game and realise their potential. If any of those talents become star players, you can then sell them to another team and make a good profit. Your investment would have paid off!
That’s how VCs work. They find their star companies, invest money into them, spend time nurturing them and when the right time comes, they sell their investment and pocket a profit. That’s a simplistic way of understanding how VCs make money.
But that could be true of angel investors as well. So, to understand what sets angel investors apart from venture capitalists, we need to understand how venture capital funds make money.
A classic venture capital firm functions through setting up of funds – each of these funds are bound by a Limited Partner Agreement. The LPA involves financial investors in the fund, such as pension funds, endowment funds, trusts, high-net worth individuals, etc., and the fund manager, who actually makes investment decisions. The fund managers are the folks that you, as a startup founder, usually interact with.
The LPA is designed such that the fund has two main income streams:
1. Management Fees :
It is the fees VC firms collect for managing funds. This goes towards paying fund managers and other operational expenses. They are calculated as a percentage of the fund’s value every year. Usually, this is between 1.25% to 2.5%.
2. Carry :
Carried Interest or carry is where the meat of the money comes from. Carry is the amount of money that VCs get when their startup investment pays off.
Suppose a startup that a VC has invested in grows and makes profit, or has an exit through a buyout or an IPO - the first bulk of that return will go towards the LPs until they recover their initial investment plus a hurdle return. Any profit over that initial investment will also be distributed to the VC.
Usually, VCs have a carry of 20%-30% of the additional return generated post the hurdle rate. This means that if the startup has made a profit of $100 million, then between $20 and $30 million will go to the VC, depending on the LPA.
What Happens if a Startup Fails?
If a venture-backed startup fails, then the VCs lose money – not just their investment amount, but also the potential gains. If the startup is sold at a loss, then VCs may be able to recoup some of their investment.
Apart from the monetary loss, VCs may also stand to lose their reputation because the market will then doubt their ability to make sound investment decisions. The months or years spent mentoring the startup and helping its network will also go in vain.
Why Is It Important For You As a Startup Founder to Understand How VCs Make Money?
Understanding how VCs make money is important when you make the decision about which VC you choose to pitch to and how. Remember, it isn’t just about the money for you.
VCs bring a lot of other benefits like networking and mentoring that will help your startup succeed. And that’s interlinked with key aspects of how the money works.
1. How is the Carry Split?
It’s important for you to gauge how balanced the carry split is in the VC partnership. If the person or people you have pitched to will sit on the board of the fund and receive more carry, they are more likely to be invested in your company.
If the founding partner, who didn’t turn up to your pitch-meet, bags more of the carry, then other partners are less likely to be as invested in watching you succeed.
So, before you decide to take a VC investment, understand how the money is structured within the firm.
2. How big is the VC fund?
Believe it or not, the size of the VC fund matters. Your startup is just one egg in their basket of eggs. If a VC fund has too many companies that it invests in, it is less likely to give you the support you want when you need it.
While big firms may have better networks and clout, you need to understand how interested they are in watching you succeed and what kind of impact your failure will have on the fund.
3. Are they charging you reasonably?
Always check what the management fees and carry rates of other VCs are before you narrow down on a fund. If a fund has a history of asking for a large portion of equity, make sure it is worth it.
Check their history of success in investment, which will tell you how much support they provide to companies in their portfolio.
4. How should you pitch to them?
Of course, you want to put your best foot forward and show that your company is capable of making good returns. At the same time, make sure you know which other interests of theirs you are playing into.
Are you planning to sell your company to another investor in the future or do you prefer an IPO? Is that what the VC fund prefers too? Make sure you understand this before you pitch to them.
You should never enter a process without fully understanding how it works. Venture capital funding is crucial for a startup to succeed, so it’s important you learn how VCs make money.
Armed with this information, you will be able to strike a better deal, find a fund that is most suited to you and get all the support you need to grow into the company you deserve to grow into.