Venture capital (VC) investments are made through a fund that is created and managed by a VC investment firm, referred to in the industry as the general partner (GP). Each fund typically has a lifespan of 8 to 12 years in which to enter into and exit from all of its investments. Prior to soliciting commitments to the fund, GPs will set a fundraising target and outline a specific strategy for the fund, such as preferred industries, regions and financing sizes.
GPs generally supply of small portion of the capital for each fund and then turn to institutional investors, high-net worth individuals and other entities with large capital pools, collectively known as limited partners (LPs), to supply the rest. LPs commit to invest a particular amount of capital into the fund, but are not required to deliver the money immediately. Once the GP has raised an adequate amount of capital, the fund is closed and investment begins. In some cases, a fund can make an investment prior to the final close. When GPs identify suitable investment opportunities, they “call down” the required capital from the LPs in proportion to their original commitment.
Sourcing Deals and Investing
Now that the GPs have procured capital for the fund, it is their responsibility to seek out prudent investments. Sourcing deals is an arduous process that typically requires a dedicated team to identify investing opportunities, conduct research and due diligence and carry out other essential tasks prior to investment. Most GPs aim to invest the entire value of the fund within five years to ensure they return capital to their investors in a timely fashion.
VC investing almost always involves minority-stake financings in early stage startups seeking capital to grow and scale their business. Companies that have never received VC financing may receive “seed” funding, typically provided to businesses less than two years old but with a novel idea or strong potential in the market. Seed funding generally ranges from $500,000 to $2.5 million, but startups have been known to receive less or more, depending on the situation. If the company meets certain targets and the VC firms involved believe the company is primed for further growth, additional minority-stake financings may follow.
Series A financings, usually next after seed funding, tend to involve additional VC firms and range in size from about $2 million to $7.5 million. Follow-on rounds generally get larger and are subsequently named “Series B,” “Series C,” and so on.
Monitoring Portfolio Companies
Unlike private equity firms, venture capital GPs do not usually own a majority stake in their portfolio companies. However, legal and nonlegal responsibilities that both the VC-backed company and GPs abide by tie the two entities together in a mutually beneficial relationship.
In exchange for an equity stake in the company, VC firms are granted seats on the business’ board of directors, often receive preferential terms for when the company is sold and may also hold other rights, such as voting rights and the ability to receive dividend payouts. The GP, in an effort to ensure its portfolio company succeeds, will provide advice, connections and other management help for the startup. They also use their position on the board to influence the company’s direction and vote in ways they believe will be beneficial for the startup’s long-term success.
In the event a VC firm or group or VC firms own a majority stake in the company, the management and monitoring of portfolio companies doesn’t usually change and they will often follow the same principles and rules outlined above.
All of the work outlined in the previous stages is building toward one goal for the GPs: the exit, also known as a liquidity event. VC firms typically have two choices when it comes time for exit, each with their distinct advantages and drawbacks. The most common exit method has traditionally been the corporate acquisition, in which a well-established company purchases the portfolio investment for strategic purposes. The second-most popular exit option—and often the most high-profile—is the initial public offering (IPO), which moves the company from the private to the public sphere. VC firms that choose the IPO route typically sell a portion of their shares after the initial lock-up period ends and fully exit their position within a year or two. GPs may also transfer their publicly traded shares to their limited partners.
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