How does a VC fund actually work

How does a VC fund actually work

By Oleksii Yermolenko, co-founder & partner at F1V

About 90% of startups die. And yet, only in 2021, venture capitalists invested $643 billion in them.

Why would they do this?

VCs help where banks can’t

A man named Lucas wants to launch an innovative Spanish teaching website. He knows how to turn it into a business in the U.S. and Britain but needs $100,000 to hire programmers, teachers and marketers in these countries.

Lucas goes to the bank. But, in the banker’s eyes, the idea looks ordinary and too risky to invest. Plus, Lucas has no collateral for a loan and a mortgage to pay off. His family doesn’t have this money.

This is where VC funds step in.

They know the e-learning market size will reach 400 billion by 2026 and Lucas’s idea looks promising. Unlike banks, VC funds are ready to make high-risk, high-reward investments, putting money into innovative businesses with high growth potential.

Lucas will have to give away part of his company’s shares to a VC. But if his idea fails, he won’t have to pay the debt.

Making money work

A venture capital fund is like Robin Hood! Just kidding.

Insurance firms, pension funds and people who have savings to invest put their capital together and trust it to a VC fund. Each of them becomes an investor and stakeholder in the fund.

The fund’s managers, in turn, use their expertise to invest the money in what they think may bring profit. Investors into VC usually can’t directly impact decisions about what companies to invest in, but they discuss the high-level investment thesis of the fund before participating.

Investment thesis is a set of criterias according to which VCs choose companies to invest in. It includes geography, industries, stages, business models, and so on.

Some people decide to invest their money in startups themselves. In the VC world, they are called angel investors.

Economics of a VC fund

When a VC fund puts in money in a startup, it gets a stake in the company. In general, a VC firm will look to get 10-20% in an early-stage startup. Then, a fund waits for an opportunity to sell its shares at a much higher price (10x and more) and make an exit.

There are four options for an exit:

1. IPO. When shares of a startup start trading on a stock exchange (including the shares owned by a VC fund) are bought by the general public. 2. A big company buys the startup. All the shares are sold and a fund receives the money for them. 3. Reselling shares. At a startup’s later stage, someone may want to buy the shares owned by a fund. 4. Bankruptcy. It’s also an exit.

What happens next? A fund receives the money and pays its own investors (at this stage — without interests or bonuses).

An example with numbers: If it’s a $1 million fund and it has 10 investors who put in the same amount of money, it returns $100,000 to each of them. If the first exits brings $500,000, each investor gets $50,000 and waits for other exits to return the full sum.

In most cases, fund starts distributing bonuses — and making money for itself — only after it has returned the initial sum.

After the initial sum of investments into VC is returned, everything on top distributes as following: fund investors will receive 80% of the extra cash, a fund will receive remaining 20% as “carried interest”. If it returned $1 million, and then there was another exit worth $100,000, investors get $80,000, the fund — $20,000.

The first VC firm

It’s considered that the first VCs appeared in the 1950s in Silicon Valley. Arthur Rock, an investment banker from Wall Street, played a key role. He gave a group of inventors $1.38 million to open a lab and develop a new type of transistor. These inventors were later dubbed Traitorous Eight. They created companies like Intel, Xicor, Intersil, and others. In 1961, Rock moved to California and established Davis and Rock, the Bay Area’s first venture capital company.

Why some invest at early stage, others — Series C?

That’s simple. Different stages have different risk and return profiles. The higher the stage, the lower the risk.

Some funds choose to invest less money in more startups. Or they may prefer to invest at early stages if they are familiar with the startup’s market, know how to help develop the idea and, as a result, have more confidence the venture will bring them profit.

If I were Lucas with his Spanish teaching website idea, I’d go to a VC who invests at early stages, knows the educational tech (edtech) market, and can help with advice and networking.

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