Fundraising is a challenge for every company. Young companies and start-ups in particular usually have a number of hurdles to overcome before they find a suitable financing partner, such as venture capital financing through private equity. Financing through outside capital is often difficult for early-stage companies; this is because collateral is rarely available and the business model has not yet been sufficiently tested. Therefore, early-stage companies and start-ups often seek equity financing, for example from business angels, corporates or venture capital companies. This article explains the structure and objectives of such a venture capital company.
How does venture capital work? - The most important contents summarized:
- Venture capital companies are institutional investors who follow a strict exit strategy following the investment.
- A venture capital company consists of a general partner (fund manager) and limited partners (investors).
- The venture capital company generates income through the management fee and carried interest.
The content of this article is based on our personal experience. It does neither constitute nor replace legal advice. If you have any questions on financing rounds or company valuation, we are happy to advise. Get in touch using our contact form or arrange your first free consultation.
If you want to learn more about venture capital funding erfahren möchtest, check out our all-inclusive guide on the topic: Venture capital funding: A beginners guide
Unlike lenders, venture capital funds actively support their investments and pursue a clear exit strategy within a specified period.
Venture capital funds invest in early-stage and fast-growing (private) companies and startups in order to meet the return expectations of capital providers (limited partners). Since VC funds are usually closed with a fixed term of 10 years, for example, they aim to increase the value of their investments as quickly as possible and to sell them within their fund term (exit). Possible exit scenarios can be acquisitions, secondaries (sale of shares to another VC or private equity company) or the exit as part of an IPO or SPAC. That is why VCs only invest in companies with enormous growth potential that have the opportunity to generate the expected return within the fund's term.
In contrast to lenders, such as banks, a VC not only provides venture capital, but also ensures that it has a say in articles of association in order to be able to actively influence the positive performance of the portfolio company. In addition, a VC makes its know-how and network available to support the growth of the portfolio companies.
A VC is made up of the General Partners, who run the fund and make investment decisions, and the Limited Partners, who are the fund's main financiers.
A typical venture capital company consists of the GPs (general partners), who set up the company and manage the fund, and the LPs (limited partners), the capital providers of the fund, which are, for example, public investors, institutional investors, corporates and high net worth private investors. The investment of the LPs usually fills the majority of the fund volume, but the partners of the GP are often expected to invest a substantial part of private assets in order to compensate for the lack of access to the investments made and to have confidence in the acting partners of the GP. In contrast to the GPs, who hold unlimited liability with their assets for the liabilities of the companies, the LPs are not unlimited liable, given they have paid their marked capital. Due to the structuring as a closed fund with a term of 7 to 12 years, investments in venture capital funds are considered illiquid for the LPs.
The venture capital company generates income through the management fee and carried interest.
A venture capital company generates income in two ways: through the management fee and the carried interest ("carry").
The management fee is used to finance the company's day-to-day business, for example, to pay the salaries of partners and employees as well as other operating expenses. The management fee depends on the fund volume and in most companies is around 2% of the fund volume per year.
The other, and more decisive, income channel is called carried interest, or “carry”. The carry is calculated as a share of the income that exceeds an agreed threshold value (IRR p.a.). If the fund's return exceeds the threshold value (e.g. 25% IRR p.a.), around 20% of the excess profit is usually distributed among the GPs as carry. The LPs receive the remaining 80% as an additional return on their initial investment. The following sample calculation illustrates the expected return on investment of a € M 150 fund with a fund term of 10 years and a guaranteed IRR of 25%.
An initial investment of M € 150 in T0 results in a payment of M € 1,397 to the LPs within the fund term of 10 years. With an excess return of M € 193 (payout T10: M € 1,590), the GPs would receive a carry totaling € M 38.6 (20% of M € 193), the remaining € M 154.4 go to the LPs.
Before choosing an investor, it is essential to check the lender's goals in order to ensure harmonious interests.
Taking into account the functioning of venture capital companies, founders should be aware of the incentives and motives that are relevant for the investor when working together. A VC, for example, depending on its orientation, will always insist on the path with the highest growth potential when making value-driving decisions (often the decisions with the highest risk) in order to be able to achieve its expected return. In addition, a VC will always strive for an exit in order to realize the income generated from the growth of the investment company. As a founder, you should be aware of this before approaching such an investor in order to ensure harmonious interests in the later cooperation.
At Trustventure, we advise young companies and start-ups on financial matters and offer CFO-As-A-Service. Our expertise in questions of corporate finance, planning and controlling creates transparency and security for you and your investors. Get in touch using our contact form or send us an email via firstname.lastname@example.org.