Here are The Mechanics of Venture Funds

Added: (Mon Nov 14 2005)

Pressbox (Press Release) - Here are The Mechanics of Venture Funds

A Venture Fund generally forms when professionals with strong financial backgrounds come together and decide to create a fund to invest in a specific sector they perceive to represent a strong growth opportunity. These folks commonly have MBA’s from Top 10 business schools and Wall Street experience at large investment banks. Some venture capitalists have been very successful entrepreneurs and have invested their own money in the fund, thereby bringing a wealth of business operations experience and savvy to the table. The vast majority of venture capitalists, however, have not served in executive or entrepreneurial roles, and identifying those who have is an added bonus.

Typically, venture fund managers raise $50 million or more from institutional investors—state and corporate pension funds, university endowment funds, and large insurance companies, as well as wealthy individuals—to form the venture fund. Private equity funds operate in an almost identical manner to venture funds, but focus on later stage companies and/or buyouts, and often raise several hundred million to a couple of billion in each fund. The institutional investors are known as “limited partners” or “LPs” in the venture or private equity fund. The venture fund creators and day-to-day managers are “general partners” or “GPs”.

Venture fund managers, GPs, or venture capitalists are compensated as follows:

1. Annual management fee—this fee is generally 2% of the fund. For example, a $100 million fund would pay $2 million annually. These monies are used for the partner and staff salaries, office and other overhead costs for the venture firm.

2. Carried Interest—VCs get a 20% carried interest in the fund. This means that after the fund is invested and the portfolio of investments is liquidated—through IPOs, mergers or recapitalizations—the venture fund managers get 20% of the profits, assuming that the limited partners realize at least a “hurdle” rate of return, which is usually 8%. If, for instance, a $100 million fund grows to $200 million over seven years—a 10% annualized return—the venture fund managers split 20% of the $100 million profit, or $20 million.

It’s important to note, however, that a compensation arrangement has several nuances. For example, the 2% management fee may count against the 20% carried interest. So if a $100 million fund doubled in seven years, generating a profit of $100 million, the venture capitalists would get $20 million of the profit, less $14 million in management fees that were already received (seven years x $2 million per year = $14 million). Thus the carried interest would only yield a net profit of $6 million. This is precisely why VCs are motivated to invest the fund sooner rather than later, so the deduction of the annual management fees from the carried interest impacts the general partners less on the net compensation amount to them at the end of the fund.

The percentage of the company that venture firms take is calculated as follows: they negotiate a pre-money valuation (I’ll explain how they come up with this number in the next chapter). A pre-money valuation is how much the venture firms determine your company is worth before putting their money in. Then they factor in how much money they will put into your company. Take the pre-money valuation, plus how much money they will invest, and you get the post-money valuation. Divide how much they will invest by the post-money valuation, and you get the percentage of the company the venture firms will take. For example, our pre-money valuation was $8 million and the venture firms decided to put in $3.5 million. Thus, our post-money valuation was $11.5 million. The VC’s $3.5M divided by $11.5M is approximately 30%.

Pre-money valuation + investment total = Post-money valuation

Post-money valuation / investment total = percentage of company the VCs will own after an investment

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