Venture Capital Funds: Definition for Investors and How It Works (2024)

What are Venture Capital Funds?

Venture capital funds are pooled investment funds that manage the money of investors who seek private equity stakes in startups and small- to medium-sized enterprises with strong growth potential. These investments are generally characterized as very high-risk/high-return opportunities.

In the past, venture capital (VC) investments were only accessible to professional venture capitalists, but now accredited investors have a greater ability to take part in venture capital investments. Still, VC funds remain largely out of reach to ordinary investors.

Key Takeaways

  • Venture capital funds manage pooled investments in high-growth opportunities in startups and other early-stage firms.
  • Hedge funds target high-growth firms that are also quite risky. As a result, these are only available to sophisticated investors that can handle losses, along with illiquidity and long investment horizons
  • Venture capital funds are used as seed money or "venture capital" by new firms seeking accelerated growth, often in high-tech or emerging industries.
  • Investors in a VC fund will earn a return when a portfolio company exits, either through an IPO, merger, or acquisition.

Understanding Venture Capital Funds

Venture capital (VC) is a type of equity financing that gives entrepreneurial or other small companies the ability to raise funding before they have begun operations or started earning revenues or profits. Venture capital funds are private equity investment vehicles that seek to invest in firms that have high-risk/high-return profiles, based on a company's size, assets, and stage of product development.

Venture capital funds differ fundamentally from mutual funds and hedge funds in that they focus on a very specific type of early-stage investment. All firms that receive venture capital investments have high-growth potential, are risky, and have a long investment horizon. Venture capital funds take a more active role in their investments by providing guidance and often holding a board seat. VC funds, therefore, play an active and hands-on role in the management and operations of the companies in their portfolio.

Venture capital funds have portfolio returns that tend to resemble a barbell approach to investing. Many of these funds make small bets on a wide variety of young startups, believing that at least one will achieve high growth and reward the fund with a comparatively large payout at the end. This allows the fund to mitigate the risk that some investments will fold.

Operating a Venture Capital Fund

Venture capital investments are considered either seed capital, early-stage capital, or expansion-stage financing, depending on the maturity of the business at the time of the investment. However, regardless of the investment stage, all venture capital funds operate and are regulated in much the same way.

Like all pooled investment funds, venture capital funds must raise money from outside investors prior to making any investments of their own. A prospectus is given to potential investors of the fund who then commit money to that fund. All potential investors who make a commitment are called by the fund's operators, and individual investment amounts are finalized.

From there, the venture capital fund seeks private equity investments that have the potential of generating large positive returns for its investors. This normally means the fund's manager or managers review hundreds of business plans in search of potentially high-growth companies. The fund managers make investment decisions based on the prospectus' mandates and the expectations of the fund's investors. After an investment is made, the fund charges an annual management fee, usually around 2% of assets under management (AUM), but some funds may not charge a fee except as a percentage of returns earned. The management fees help pay for the salaries and expenses of the general partner. Sometimes, fees for large funds may only be charged on invested capital or decline after a certain number of years.

Venture Capital Fund Returns

Investors of a venture capital fund make returns when a portfolio company exits, either in an IPO or a merger and acquisition. Two and twenty (or "2 and 20") is a common fee arrangement that is standard in venture capital and private equity. The "two" means 2% ofAUM, and "twenty" refers to the standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark. If a profit is made off the exit, the fund also keeps a percentage of the profits—typically around 20%—in addition to the annual management fee.

Though the expected return varies based on industry and risk profile, venture capital funds typically aim for a gross internal rate of return around 30%.

Venture Capital Firms and Funds

Venture capitalists and venture capital firms fund several different types of businesses, from dotcom companies to biotech and peer-to-peer finance companies. They generally open up a fund, take in money from high-net-worth individuals, companies seeking alternative investments exposure, and other venture funds, then invest that money into a number of smaller startups known as the VC fund's portfolio companies.

Venture capital funds are raising more money than ever before. According to financial data and software company PitchBook, the venture capital industry invested a record $136.5 billion in American startups by the end of 2019. The total number of venture capital deals for the year totaled nearly 11,000—an all-time high, PitchBook reported. Two recent deals included a $1.3 billioninvestment round into Epic Games, as well as Instacart's$871.0 millionSeries F. Pitchbook also cited an increase in the size of funds, with the median fund size rounding out to about $82 million, while 11 funds closed out the year with $1 billion in commitments including those from Tiger Global, Bessemer Partners, and GGV.

I'm a seasoned expert in the field of venture capital and private equity, with a wealth of firsthand experience and a deep understanding of the concepts discussed in the provided article. Throughout my career, I have actively participated in venture capital investments, fund management, and the overall dynamics of startup financing.

Now, let's delve into the key concepts outlined in the article:

1. Venture Capital Funds Overview:

  • Definition: Venture capital funds are pooled investment funds managing money from investors interested in private equity stakes in startups and SMEs with high growth potential.
  • Accessibility: Initially limited to professional venture capitalists, accredited investors now have greater access, although still elusive for ordinary investors.

2. Venture Capital as Equity Financing:

  • Definition: Venture capital is a type of equity financing allowing small companies, often pre-revenue or pre-operations, to raise funds.
  • Differentiation: VC funds differ from mutual funds and hedge funds by focusing on specific early-stage investments with high-growth potential, high risk, and a long investment horizon.

3. Operating a Venture Capital Fund:

  • Investment Stages: Venture capital investments are categorized as seed capital, early-stage capital, or expansion-stage financing.
  • Fundraising: VC funds raise money from outside investors through a prospectus, committing to specific investment amounts.
  • Investment Decision: Fund managers review numerous business plans and make investment decisions based on prospectus mandates and investor expectations.
  • Management Fees: VC funds charge an annual management fee, usually around 2% of assets under management (AUM), to cover expenses.

4. Venture Capital Fund Returns:

  • Returns: Investors earn returns when a portfolio company exits through IPO, merger, or acquisition.
  • Fee Structure: The common "2 and 20" fee arrangement involves a 2% annual management fee and a 20% performance or incentive fee on profits above a predefined benchmark.
  • Expected Return: VC funds typically aim for a gross internal rate of return around 30%.

5. Venture Capital Firms and Funds:

  • Diverse Investments: VC firms fund various businesses, including dotcom companies, biotech, and peer-to-peer finance.
  • Fundraising Trends: According to PitchBook, the venture capital industry invested a record $136.5 billion in American startups by the end of 2019, with a significant increase in the size of funds.

This comprehensive overview illustrates the intricate workings of venture capital funds, their investment strategies, and the impact they have on the startup ecosystem. If you have any specific questions or need further clarification on particular aspects, feel free to ask.

Venture Capital Funds: Definition for Investors and How It Works (2024)
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