Venture Capitalists: How Do They Make Money?

By Fernando Berrocal

How do Venture Capitalists (VCs) operate? VCs have bosses which are Limited Partners (LPs). To please them, VCs must fulfill Key Performance Indicators (KPIs) and goals, just as startups must also do. To increase their chances of receiving investment, every business founder should have as much background as possible about how a VC fund functions and how they judge their performance.

How are Venture Capitalists profitable

Venture Capital's Beginnings: The origins of Venture Capital as an asset class may be traced back to whaling. Although the relationship may not seem obvious, they both have the same architecture: a capital source and a major investor. Wealthy individuals with enough excess capital to participate in a risky enterprise would be the capital providers in the whaling business. These individuals, known as LPs, provide funds to a whaling agent (VC business) to fund the expedition.

A successful expedition, like a VC investment today, was unusual, but it had the potential for huge profits. In reality, a whale expedition's return profile was remarkably comparable to that of a venture capital investment today. In both cases, a capital source provides funds to an agent, entrusted with the funds to execute an expedition in search of financial gains. Consider each VC's fund as a journey, with the businesses they invest in serving as the ship, the captain as the founder, and the workers as the crew.

A VC's business model is obvious in this context. However, since the days of whaling, the business model has changed, and there are new methods for VCs to generate money and be judged. What hasn't changed is the requirement that these funds and expeditions generate far greater rates of return than a regular investment for the fund to be profitable.

Glossary of VC Terms: Before we get into the nitty-gritty, there are a few phrases you should be familiar with:

  • LPs: Limited Partners, or the fund's investors, are referred to as LPs. Pension Funds for Unions/Teachers, sovereign wealth funds of governments, or Hedge Funds/high net worth people.
  • Assets Under Management (AUM): Refers to the entire amount of money that the fund has raised and invested.
  • Exit or "Liquidity Events": When a business is purchased by another business or a fund. Typically, this is a mix of cash and shares, with the investors receiving a proportionate return on their investment.
  • Ownership %: This is the % of the business that the fund controls.
  • "2 and 20": This means a 2% charge on AUM and a 20% profit share.
  • Internal Rate of Return (IRR): This is determined by "marking up" an investment to its most current value. That is unlikely to happen again, thus most investors aim for a 30% IRR throughout a fund, understanding that the majority will sink to 0. You may argue that IRR is a careless calculation since it is dependent on valuation, which is a subjective evaluation of an organization's worth.
  • Total Value to Paid-in Capital (TVPC): Total value of assets divided by the total value of capital 'called' by the fund.
  • Distributions to Paid-in Capital (DPC): Its formula is the amount of money returned to LPs divided by the total amount invested into the fund. Both the TVPI and the DPI have the same denominator, but the DPI reflects how much money the fund has returned to its investors rather than the marked-up value the fund has calculated.

2 and 20: This is a simple term that encapsulates the main business strategy of a VC fund: "A 2% management fee and a 20% carried interest". The management fee is used to fund day-to-day operations, while the carried interest is provided to investors as a performance incentive. Carry interest is sometimes referred to as a fee that is calculated as a proportion of the profit a fund makes on an investment. Returns are measured "net of fees" from the LP's standpoint. To simplify it, consider the following: Ending value of LP investment minus (original capital invested + carried interest + management costs) equals performance.

Typically, the management fee is 2% of the entire AUM. If you manage a $100 million fund, you'll have $2 million to work with. This will include office space and professional services such as auditors and accountants, and anything else that will help businesses increase their profile. Regardless of the size of the fund, the management charge is usually approximately 2%. The carried interest, or "20," varies depending on the fund.

How Are VCs Profitable

Measuring the performance of a venture fund: The truth is that much of an organization's 'growth' is 'on paper,' and the monetary worth isn't realized until it is sold or goes public. The absence of profitability and liquidity is one of the most significant distinctions between a VC-backed business and a regular cash-flow positive corporation. In a conventional "main street" business there is a projected time range for profitability. Once that number is reached, the business owner can begin keeping earnings for herself and the venture's investors on an annual or quarterly basis.

That is not how VC-backed businesses operate. In a VC-backed business, there is a fundraising milestone-based structure in place: if the business can make X sales (likely still not profitable), money will be available to get it to Y valuation. The value is what the investor believes the business can attain in a reasonable amount of time, however it is frequently based on a combination of quantitative and qualitative reasoning. As the organization expands and its value increases with each succeeding fundraising round, the VC's books are "marked" as such. However, this does not ensure that the business will maintain or exceed its current worth.

In conclusion, "Venture Capital" was established to describe the financing of whaling expeditions, and VC is a high-risk, high-reward endeavor. "Management fees" and "carried interest" are two ways VCs generate money. Measuring VC success is both an art and a science, similar to determining an organization's value. Finally, the "2 and 20" strategy is used by most VC funds to support their operations while also earning carry-on profitable investments.

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