How Do Venture Capitalists Make Money?
The venture capitalist invests funds in a startup that is poised for growth in exchange for an ownership interest in the company.3 min read
How do venture capitalists make money? The venture capitalist invests funds in a startup that is poised for growth in exchange for an ownership interest in the company. Although this may not carry much worth at the time of the initial investment, the venture capitalist hopes the company will become more valuable and exponentially boost the value of his or her stock shares.
Eventually, the company will ideally begin to trade on the stock market with an initial public offering (IPO) or sell to a larger company for a higher price. Either way, the venture capitalist will be able to cash in at that point by selling his or her shares.
What Are General and Limited Partners?
Venture capital funds raise money from traditional investors who act as limited partners. These partners could be pension funds, banks, insurance companies, university endowments, or other financial institutions. Venture capitalists invest these funds into risky investments such as startups that are likely to provide an annual return on investment (ROI) of at least 12 percent. This allows for rapid growth of compound interest, unlike with traditional investment funds bound to 10 years with only three to five years of active investing.
When the venture capital fund is able to sell its shares in an investment for a profit, 20 percent of the amount earned is retained by the administrators of the fund (general partners) while 80 percent is paid to the limited partners. General partners also receive salaries and reimbursed expenses each year that equal 2 to 3 percent of the total venture capital fund amount. Carried interest often pushes this percentage even higher.
How Does It Work?
Let's look at a $300 million capital fund in which the limited partners have committed capital to a specific startup for 10 years. Most venture capital funds aim for ROI of at least 10 times their initial investment. That's because they must earn at least three times their initial investment to raise funds for the next venture, so the higher goal compensates for investments that flop.
Using the example above, a three-times return would be $900 million. $300 million is returned to the limited partners, leaving $600 million to split between all partners. General partners get 20 percent, which is $120 million, while the limited partners receive $480 million. This represents a 160% percent return on investment.
Out of every 10 startup companies, only two will experience the exponential growth that venture capital firms need to create profit. The longer the fund length, the greater the opportunity to succeed. In some cases, a 10-year fund may be cut in half if the company is not showing enough profit and growth. Reducing the desired profit from 12 percent to 8 percent makes room for non-traditional investors.
What Are the Profit Categories?
- Carried interest is the most profitable part of the deal for a venture capitalist. In the example above, the investors earn 20 percent on every dollar over the initial investment amount.
- Investors also make money through a management fee, which is charged to limited partners as the cost of participating in the venture capital fund. This is often 2 percent of the total value of the fund. In the example above, that would equal $6 million per year.
- Managing multiple funds at once increases profit. In general, a venture fund lasts seven to 10 years and most firms try to raise money for a new fund every two to three years. The general partners earn money from every active fund, including both carried interest and management fees.
Why Should My Company Seek Venture Capital?
Companies need the right idea with the right people at the right moment to truly succeed in business. If you want to attract venture capital firms, build an outstanding team dedicated to working toward your business goals. For tech companies, investment capital funds research and development, marketing, and growth, usually to the tune of tens of millions to billions of dollars.
Having a venture investor who can advise your company as a board member is incredibly valuable when it comes to expanding your customer base, fine-tuning your market strategy, recruiting the best team members, and ultimately succeeding.
If you need help with making money through venture capital, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.