Ask an Investor: How does a VC firm work?

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How a venture capital fund works behind-the-scenes can be quite confusing and opaque, even for entrepreneurs who spend a lot of time talking to investors. There are some common elements that need to be understood and some specificities that can help you better navigate in this space.

About the structure

A venture capital fund is typically structured as a partnership between General and Limited Partners. In this structure, the Limited Partners (LPs) do not have decision-making authority. The General Partner (GP) is tasked with all of the responsibilities associated with the fund’s daily operations and is responsible for the execution of the fund’s mandate. The GP is typically a separate corporate entity, where the shareholders are the Partners of the fund. The GP must manage the fund in accordance with the Limited Partnership Agreement (LPA). The LPA clearly sets out the terms of the partnership, the fund’s investment strategy and the responsibilities of both GP and LPs. LPAs, therefore, vary substantially across partnerships. However, the GP’s fiduciary responsibility to act in the best interest of the LPs is legally binding and a constant in all LPAs.

The key point for founders to understand is that VC type of returns are very difficult to obtain and may not be achievable in some industries or businesses.

What it means to a founder: Some funds will have a very strict and focused investment mandate (investment stages, industry focus, etc.) while others might be more broad in nature. Despite the fact that the LPA is a private document, VCs tend to disclose the fund’s mandate on their website or discuss it with founders. At Impression Ventures, we focus exclusively on identifying and investing in FinTech companies – our partners have substantial expertise in financial services, technology and possess relevant entrepreneurial experience.

We stick to what we know, and more importantly to opportunities that fit our mandate. As a result, we can quickly pass on investments that fall outside of our FinTech mandate. As a founder, understanding a VC’s mandate can save you significant amounts of time.

Where does the money come from?

In the same way that startups turn to VCs for their fundraising needs, VCs do the same with their LPs. While there are many different categories of LPs, the vast majority fit within the two categories below:

  • Institutional: Insurance companies, Banks, family offices, fund of funds, sovereign funds, foundations and endowments, pension funds
  • Individual: High net worth, The GP directors themselves (also known as the Partners). It is not unlikely to see directors investing their own money in the fund and be involved as LPs as well as GP. It reinforces the alignment of interest and mitigates the principal-agent problem.
  • Ideally, the fund’s LPs would have entrepreneurial experience, industry specific knowledge and broad networks. While it is not explicitly required of the LPs, VCs that can mobilize their LPs to assist and advise their portfolio companies offer a substantial value add proposition.  

    Note that a VC investment is typically part of a well-diversified portfolio. Investors look to combine multiple uncorrelated assets with different risk/return profiles to achieve optimal investment returns. An investment in an early stage VC fund is typically referred to as an alternative investment and considered to be a higher risk, higher return investment. The GP’s role is to deploy the fund’s capital in promising early stage, high potential companies and create substantial Alpha for its LP investors.

    VC investment receives a lot of attention from the press and facilitates business creation and growth. However, while the popularity of VC investment is growing, it is still a relatively small asset class. In 2017, the global VC industry has invested $165 billion USD in startups. As a point of comparison, the 3 “A” tech giants-Amazon, Apple, and Alphabet- spent more than $50 billion together in R&D, the wider private equity industry raised over $450 billion USD, and the hedge fund industry manages approximately $3 trillion USD globally.

    What it means to a founder: Founders rarely ask for the fund’s LP’s typology when they pitch. But they should! This can be very informative, as it helps to understand what is the real network effect that could be expected from an investor, or if the VC’s network is even relevant to the startup. Many LPs really emphasize the word “partner” in “limited partner” and will make introductions, provide unique views or industry insights, and may, one day, potentially lead your next round! This is certainly the case at Impression Ventures where our LPs always stand at the ready to assist our portfolio companies.

    How do VCs make money?

    More specifically, how does a GP generate revenues and profits, and how are its employees and partners compensated?

    The most common revenue model is typically referred to as the 2/20:

  • Where “2” represents an annual percentage of assets under management which provides a fixed compensation. These fees will help cover the operational expenses of the fund: employee salaries, travels, office rent, etc.
  • Where “20” represents a share percentage of the profit once a portfolio investment has been sold. Investors get 80 percent of the profits while the GP will receive 20 percent of the profit. The profit calculation also takes into account an annual preferred return to LPs. This type of compensation is commonly referred to as carried interest or just “Carry.” It ensures a strong alignment of interests between GP and LPs.
  • What it means to a founder: While the fee structure is typically kept private and described in the LPA, founders should be aware that in bigger funds (i.e: $300M+), the 2 percent fixed fee represents a significant amount of money and could potentially alter the GP’s behaviour toward risk and lead to a misalignment of interest. On the other side, an over-reliance on the 20 percent upside can encourage “cherry picking,” and cause managers to focus intensively on the one or two portfolio companies for which big IPOs are possible.

    Understanding VC returns

    VCs typically report returns in terms of Internal Rate of Return (IRR), as per a majority of the investments opportunity across asset classes. It is important to note that IRR is both a function of time and exit multiple: a 6x exit in three years represents an 82 percent IRR and is a better (accounting speaking) outcome than a 10x exit in 4 years which represents a 78 percent IRR.

    The average VC fund has a duration of eight to 10 years. But it actually holds funds for about six years, accounting for:

  • Investment and divestment periods.
  • VC is not in the business of managing cash. LPs’ committed amounts are called gradually, as needed by the fund for deployment and redistributed as the fund exit investments.
  • Venture capital is a high risk asset class (generally earlier stage investments are riskier), and investors need to be fairly compensated for the risk they are taking. The industry common average target is a min. IRR of 20 percent, which means for a $100 million fund, the fund manager needs to return $300 million to its LPs, a multiple of 3x. The truth is LPs would be happy with this target, but not euphoric, the best VCs do better – but the majority of the funds don’t get anywhere near this target level.

    In venture capital, Normal Distribution doesn’t apply to returns, the Power Law does. Let’s take the example of the $100 million fund investing in 20 companies ($5 million total investment in each):

    Population Exit Multiple Return
    10 (50%) 0 -50
    6 (30%) 3 +90
    3 (15%) 7 +105
    1 (5%) 30 +150
    Total +295

     
    The Power Law means that a substantial part of the portfolio will fail and VCs need a home run investment to meet their return expectations.

    What it means to a founder: VCs are looking for scale-up potential in the startups they fund. As a founder, you need to show the VC community that your enterprise has a path to a 30x exit. Probabilities may be low and that’s okay, it’s part and parcel of VC investments. The VC’s role, in addition to providing funding, is to provide founders with substantial value-add to help de-risk the business and increase the probabilities of success. The key point for founders to understand is that VC type of returns are very difficult to obtain and may not be achievable in some industries or businesses. It is important for founders to understand VC returns requirements. Over the years, we’ve turned down some companies which we knew would be great businesses and generate excellent outcomes for their founders, but would not meet our return hurdles.

    Feature photo via Unsplash.

    Pauline Brunel

    Pauline Brunel

    Pauline is an Analyst at Impression Ventures, a venture capital firm focused on investing and leading deals in FinTech companies raising late seed to early Series A rounds across North America. Pauline started her career in M&A focusing on growth companies in Paris. She then switched to the Capital market side working for JPMorgan in London as an Associate, before joining the Luxembourg regulator’s alternative investments team as a Senior Officer. You can follow Pauline on twitter at @paulinejbrunel