Entrepreneurship is a craft; like any craft, a deep understanding is necessary. One of the most crucial aspects of entrepreneurship is raising capital. Capital is the fuel for the journey, and you must educate yourself on how it works. Knowing the anatomy of a fund is helpful if you plan to pitch to a VC.
A venture capital fund is typically structured as a partnership, with the firm and its principals as general partners and its investors as limited partners.
The general partners decide how big a fund they want to raise. They and their team solicit investment from high-net-worth individuals, family offices, pension plans, and other institutional sources. If investors like what they hear, they commit capital and sign agreements to become LPs of the fund. Once the fund is raised, it is closed to further investors and begins deploying capital.
The GPs/Fund Managers are responsible for deal flow. They want to see a lot of investment opportunities. They are prepared to say “no” or “not yet” to most but want to ensure they aren’t missing any opportunities. They will start the due diligence process if they find a business they like. Depending on the size of the check, due diligence can be as simple as a review of pertinent financial information such as recent P&L statements, balance sheets, and cash flow. For larger checks that might grow to a deeper analysis of syndicated data, a regulatory and compliance review, IP, and more.
After completing the due diligence process, they will often issue a term sheet if they remain interested. It will detail the specifics of the investment offer. It will likely include the pre-money valuation, class of stock, and other requirements such as data rights, board seats, information rights, and more. After review and negotiation, the fund and the entrepreneur agree and the detailed documents are drawn up, executed, and the money wired.
How do GPs and LPs make their money?
Understanding the money-making mechanics is vital. It will help you know how to frame your pitch and which funds might make sense for your business.
Although LPs commit capital, that money remains in their hands until there is a capital call. Funds do not receive money from their LPs until an investment is made. For example, if a fund has raised $100MM and each LP has committed $10MM, then each time that fund invests in a brand, each LP will receive a capital call for 10% of that investment. Once they receive notice of a capital call, they wire their pro-rata portion of the total investment to the fund for deployment.
This is important because most funds charge a management fee. The average is 2% of the funds deployed. That 2% pays for the salaries of the fund’s management and team, its offices, and other overhead expenses. So the sooner a fund makes investments, the sooner it begins earning a management fee. The larger the check, the more money goes to work to support the fund.
A fund that makes an initial investment of $1MM and receives $3MM after the sale of a business will return the initial $1MM to its LPs and 80% of $2MM in profit, keeping 20% for itself. When there is a successful exit, the fund repays each of its LPs their original pro-rata principle. They then split the upside based on the terms of LP agreements. A typical split is 80/20. The 20% is called the “Carry.”
Understanding how a venture fund works involves much more. However, this primer should help you prepare for more informed discussions with investors. If you plan to raise money from VCs, be a student of venture capital. Better knowledge of how it all works will make you more effective and confident.
