1.Introduction to VC Funds
1.1. Understanding Venture Capital: The Meaning Behind VC
In its most general sense, Venture Capital (VC) is a form of investment in startups that are in the early stages of development. The venture capitalists provide financing in exchange for the startup’s equity.
A startup is a newly-established company that needs financial resources to grow its operations. Besides being fairly young, such companies are perceived by venture capitalists as extremely promising in terms of the return on investment. In most cases, VC-supported businesses are yet to enter the phase of generating profit or even revenue.
Equity, on the other hand, can be defined as a percentage of the ownership in a startup—and that is what motivates venture capitalists to invest, especially if the company is projected to become a huge success.
In addition to financial support, venture capitalists sometimes provide technical or managerial resources to companies who came up with an innovative idea, but lack professional expertise.
Venture capital’s popularity has increased in the second half of the twentieth century, after founders have realized they need an alternative to bank loans. From the perspective of the bank, early-stage companies always carry a significant portion of risk. There’s a huge possibility that the company will ultimately fail to turn its business plan to reality and become incapable of repaying the loan.
From the startup founder’s perspective, it’s better to utilize earnings for further growth than having to use them for paying back loans with high interest rates. That’s where venture capital comes in.
The sources of venture capital come from highly-experienced investors, investment bankers, and other financial institutions. Its main characteristics are high risk, huge return potential, and long-term engagement.
1.2. What is a Venture Capital Fund?
A venture capital fund represents a pooled investment, a sum of financial resources to be committed to early stage companies that are perceived as high-growth opportunities. It is a form of investment vehicle that seeks such companies and is formalized as a partnership.
VC funds are actively involved in startups’ development. In addition to providing guidance, they often take membership in the company’s board of directors and have a role in managing startup operations.
Since venture capital funds represent pooled investments, they raise capital from external investors. VC funds can have one or more fund managers, who send prospectus documents to potential outside investors. The prospectus is a formal document, defined by the Securities and Exchange Commission (SEC) in the United States, outlining the details about an investment and helping participants make informed decisions.
One of the fundamental fund manager’s responsibilities is to review numerous business plans in order to identify potential high-growth startups. Based on this, the above-mentioned prospectus is created and handed over to prospective investors, who make or decline the commitment after analyzing it.
The next stage is finalizing the individual amounts and making investments into a number of startups that together make up the VC fund’s portfolio. Thus, in contrast to investment syndicates that focus on a single company, venture capital funds invest in multiple startups to mitigate the risk. This follows the “don’t put all your eggs in one Basket” logic; if one startup fails, the other one may be very successful.
How Venture Capital Fund Returns Work
In most cases, venture capital fund investors generate returns after the invested company exits (e.g. through an Initial Public Offering), merges or gets acquired by another business.
This is when a “2 and 20” fee structure applies, which is an industry standard in venture capital. The VC fund charges 2% fee of assets under management (AUM), as well as 20% of generated profits, provided the profit has been made after the company had exited. The assets under management represent the overall market value of investments that the fund manages on behalf of investors.
The expected return can vary, since VC funds finance a wide range of businesses from different industries. However, the funds usually target around 30% return rate per year over the lifetime of the investment.
The lifespan of a typical VC fund is around 10 years. Since venture capital is notorious for being risky, there’s another general rule: one third of the invested startups ultimately fail, another third returns only the invested capital, and the last third of startups becomes successful.
1.3. What Is a Venture Capital Firm?
The broadest definition of a venture capital firm would be an organization that raises financial resources from different sources to invest that accumulated capital into startup companies.
Venture capital firms obtain investing money from institutional investors such as pension funds, investment banks, academic institution endowments, investment funds owned by the government, insurance providers, hedge funds, and individual investors with a net worth above $1 million.
As a legal entity, a venture capital firm can include several different venture capital funds. Institutional investors are intermediaries in VC firms. They do not invest directly in startups, but operate as Limited Partners.
Investment Focus Differentiation
VC firms operate according to an established thesis. This means that each firm specializes in investing in a particular type of startups: based on a specific sector (e.g. automotive industry, dot com), stage, or geographic location. For example, the hypothetical VC firm may specialize in young companies that expand access to financial tools and knowledge about managing personal finances. There are generalist VC firms as well, investing in startups from all sectors.
1.4. Key Parties in Venture Capital
In order to have a better understanding on how venture capital works, here’s a brief overview of the key players in venture capital:
Venture capitalists generate profit by creating a market for investors, startup founders, or investment banks. They are responsible for identifying and executing promising deals, as well as running the VC firm.
Startup Founders or Entrepreneurs
These are not ordinary business people. As crucial players in the VC industry, startup founders are entrepreneurs with a strong vision that can both generate massive profits and create big changes or disruptions in a given industry.
Besides helping startup founders with legal matters like business incorporation, patenting, or representing them in negotiations with venture capitalists, lawyers are hired by VCs themselves to manage legalities related to raising capital, setting up a venture capital fund, and other issues.
In the context of venture capital, investors are individuals or institutions willing to take risk with a goal to generate high returns. They can be general partners at the top of the venture capital fund’s chain of command, or limited partners that actually provide financial resources for the fund, ie. money to be invested. Learn more about general and limited partners in the following sections.
The role of investment banks is to help entrepreneurs find investors, successfully implement Initial Public Offering, merge or get acquired by other companies. Also, investment banks can be direct investors.
1.5. VC Fund Structure In a Nutshell
As already mentioned, the VC fund is a sum of capital that will be invested by the management company, or a venture capital firm. Here’s how VC funds are structured:
Management Company (VC Firm)
The management company is an entity formed by the general partners. It can actually manage multiple venture capital funds, and is responsible for their operations. In exchange for providing investment opportunities and dealing with fund’s expenses, management companies collect fees from limited partners, and often engage in invested companies’ branding, operations, and growth strategies.
General Partners (GPs)
General partners can either be individual high-net-worth investors that partner with a VC firm, or VC firms (management companies) themselves. Usually, they deploy their own financial resources into a fund. Their primary responsibility is analyzing potential deals and making final decisions on where the collected money should be invested.
Besides management fees, general partners receive interest for sourcing deals and managing the fund. It is usually around 20% of the profits generated by the venture capital investment.
In short, the general partner’s role can be broken down into two things: 1) directing investments to innovative and promising companies and 2) raising capital for future ventures.
Limited Partners (LPs)
This is where the capital comes from. Just as VCs finance startups, limited partners finance VC funds. The collected amounts are often measured in billions; however, LPs invest only a small percentage of the money they manage into venture capital. They diversify investments through different asset classes, each carrying a different level of risk and potential return.
Relationships between limited partners and venture capital funds are formalized through limited partnership agreements (LPA). Those are contracts outlining how the capital will be invested and profits distributed among each party in a VC fund. LPAs often include clauses that protect limited partners, prohibiting VC firms from investing in problematic industries, such as gambling for example.
Limited partners tend to be the following:
- Government-owned funds that invest national surplus capital
- Pension funds (private or corporate retirement funds)
- Educational endowment funds (investing donated money with a goal to generate returns that are at least above the inflation rate)
- Family offices
- Insurance companies
- Funds of funds (investing in venture capital funds using financial resources from other LPs)
- Wealthy individuals (investing their own money)
When it comes to venture capital fund hierarchy, it can be divided into top-, middle-, lower-level and support-type roles.
Managing directors and general partners are the examples of the first category, since they are the ones who have the final word about investment decisions. Limited partners can also influence decision-making, depending on the arrangement.
Examples of mid-level roles are principals and directors; they are not involved in the actual deployment of the investment, but can influence the final outcome of a deal. The next category in the hierarchy are analysts and associates, who can have a wide range of functions. Support-type roles can include marketing, business development, or human resources specialists.
2. Venture Capital Investment Process
2.1. Key Factors in Investment Evaluation
Regardless of the venture capital firm’s focus on a specific industry or startup development phase, there are key company characteristics that influence VC investment choices.
Team & Management
This is by far the most important factor that influences venture capitalists’ decisions. According to a research by Harvard Business Review, the majority of VCs surveyed agreed that the teams have contributed the most to the failure or success of companies in their portfolios. 95% of the survey respondents argued that startup founders had the biggest influence in deciding whether to establish a deal.
Not only should management have relevant experience in the industry, but the entire team should consist of individuals who are capable of implementing what is envisioned in the business plan.
On top of that, venture capitalists look for founders with a history of leading companies that have generated significant returns for investors. Flexibility is another factor; if the business idea is excellent but the team lacks talent, the management should express the willingness to outsource experts.
Business Model & Market-Related Factors
These factors include the startup team’s ability to accurately formulate a strategy at each stage of its development, how the profits will be generated, the size of the market for a given product or service, and competitive advantage – the way the product or service solves the problem for users.
The business plan should provide detailed market evaluation, and include both third-party analysis and feedback from potential users themselves. Ideally, potential customers should demonstrate a need for the product and willingness to purchase it.
The best scenario is having a solution that addresses pain points of consumers, a large market and a small number of competitors. The bigger the market, the more options there are for the VCs to exit their investment.
Return on investment
Venture capitalists use various metrics to assess the profitability of a particular investment. These can be Internal Rate of Return (IRR), Cash-on-Cash return and other calculation methods. In any case, investors will expect to profit from the deal.
That is why it’s crucial for VCs to receive accurate projections of a startup’s long-term goals, specifically regarding how funds will be allocated at each stage of business development. Startups that have successfully secured funding have typically provided a detailed financial forecast, along with their runway. The aim of a financial forecast is to estimate the amount of capital required to operate a thriving business.
The startup runway is composed of two critical factors: gross and net burn rate. The gross burn rate reflects the amount the company spends each month. It’s calculated by subtracting the available funds from the total funds at the beginning of the year, then dividing that result by twelve months. Conversely, the net burn rate represents the difference between the company’s earnings and expenditures. It’s determined by deducting the monthly earnings from the gross burn rate.
These projections enable VCs to evaluate whether the investment will generate a return on investment or not.
2.2. Stages of Venture Capital Funding
Depending on the development stage of a given business, there are various stages of venture capital funding, each with its unique objectives and expectations.
During this stage, the capital is utilized to assist the startup in developing an idea for a forthcoming product or service. This is an informal financing stage, often involving financial resources provided by founders themselves. In many cases, startups enter business incubator programs to explore potential sources of funding. These programs offer a variety of services, such as mentoring or connecting with venture capitalists.
The funds raised during the seed stage are typically employed to facilitate the transition from the initial concept to an early product or prototype. A portion of the funds is typically allocated to Research & Development (R&D), which entails gathering information about the future market and how the product will meet the market’s needs.
Venture capitalists usually secure favorable terms from seed-stage startups, which is why they take on more risk with the expectation of achieving significantly higher returns on investment.
Early Stage Capital
At this stage, funding is utilized to support the company’s further product development efforts once a certain level of traction has been achieved. Additionally, the funds raised are allocated towards marketing activities and sales promotion, as well as strategic planning for expansion into new markets.
Series A and Series B funding are forms of early-stage financing.
During the expansion stage, companies aim to secure funding for the improvement of existing products as well as the development of new ones. This funding is also used to support the actual expansion into new markets, enhance relationships with consumers through major advertising campaigns, acquire other companies, and prepare for the future Initial Public Offering (IPO). Typically, expansion stage capital is raised through Series C funding.
Later-Stage or Exit
This phase involves securing final financing before the company embarks on an Initial Public Offering (IPO). The sources of funding in this stage are typically hedge funds or private equity firms.
2.3. Types of Venture Capital Funding
As elaborated in previous sections, venture capital investors receive a portion of company’s equity in return for providing the investment capital. They do it through the issuance of security instruments. There are different types of securities, but the most common ones are convertible debt, SAFE notes, preferred stock or equity, and highly structured preferred equity.
However, from the perspective of startup founders, these instruments can be divided into two main categories: equity, and debt. The first one refers to giving up a portion of ownership in a company through stock issuance, and the latter, as the words suggests, refers to borrowing money – either by issuing bonds or taking out a loan.
Have in mind that startups and investors may have different objectives. The founder’s main focus is the process of getting the company off the ground, while the investor’s biggest concern is return. That’s why both parties need to decide on a security instrument to be used and ensure favorable terms for everyone.
Read on to learn more about each type of security instrument most commonly used by VCs.
One of the most traditional methods of VC investing comes in the form of a convertible debt. This security instrument is designed to convert from debt to equity at some predetermined point – either in the next financing round or at the exit or liquidation stage, when an invested company enters an IPO.
The final amount that will ultimately convert to startup equity will consist of the principal amount of the convertible debt, plus interest that’s been accrued by the date of conversion. Thus, just as with traditional loans, convertible debt comes with an interest rate (usually around 2% or 3%), as well as a term of around two years.
The price at which convertible debt will convert into company’s equity is determined by one of the factors below:
Valuation cap. This is the maximum valuation at which the debt will convert. For example, a startup company may raise convertible debt at a $2 million valuation cap, and everything above that $2 million goes into valuation in the next funding round.
Discount percentage. This is the discounted rate at which the convertible debt will convert; for example 90% of the original share price.
There are benefits of convertible debt implementation for both investors and startups. VCs and founders do not need to agree on a startup valuation when defining the convertible debt terms, thus avoiding complex due diligence processes and fees. On the other hand, in case the startup exits at a lower amount than initially projected, the capital investor will be paid out before other parties engaged in investing.
This type of security instrument was popularized by Y-combinator, a well-known startup accelerator company that facilitated launching of over 4,000 companies, including names such as Reddit, Coinbase, Airbnb, Quora, and Dropbox. SAFE is an abbreviation for Simple Agreement for Future Equity.
In a similar manner as convertible debt, SAFE notes convert to equity at a future financing round (e.g. Series A funding), and also include valuation cap or discount rate. However, there is no debt involved, and consequently there are no interest rates.
The advantage of SAFE notes is that they are significantly less complex, require fewer terms to be negotiated, and are more favorable to founders than convertible debt.
Preferred equity is most commonly used in larger venture capital investments, during the later-stages of startup development. Its main characteristic is a seniority over common shares when sale or liquidation of the company occurs. To put it simply, if a startup had raised $15 million and got sold for the same amount, all the money goes to investors (and preferred equity holders get paid before common shareholders).
Preferred equity can also include anti-dilution clauses that provide additional benefits to investors. This allows them to sustain the equity ownership percentage even if new shares were issued.
Highly Structured Preferred Equity
This security instrument is typically used when investing in highly-developed, unicorn-type startups. It is a combination of convertible debt and preferred equity; for example, a company wants to raise $1 billion without prior business valuation write-down. Founder’s goal is not to go below that amount, and they create an instrument that comes with high interest rates and/or dividends.
The benefit for investors is that they have priority when liquidation or exit occurs, plus higher returns in the form of dividends or interest.
2.4. Characteristics and Features of VC Investing
In this section, we’ll describe the most important aspects that both VCs and startup founders need to be aware of before engaging in the processes of investing and fundraising.
Long Term Horizon
Venture capital investing involves a significant delay between the initial investment and ultimate returns. This implies high risk, which is why VC investments tend to feature high returns in order to compensate.
In contrast to publicly traded instruments such as stocks or bonds, VC investments do not imply short-term returns or payouts. Thus, venture capital mostly relies on the projected success of the initial public offering.
Private Vs. Market Valuation Discrepancy
There is no precise method of determining a company’s actual value on the market, since VC investments are carried out by private funds. As a result, Initial Public Offering can produce significant speculation on both buyer and seller side.
Also, startups usually develop an innovative product that will potentially disrupt the market. Because no one else has created a similar product or service before, no one can tell for sure what its actual market value is.
Conflicts of Interest
We have already mentioned that founders and VCs have different concerns; the first one is concerned about the processes, and the latter’s main interest is ROI.
Discrepancies in viewpoints may arise between limited partners and fund managers. Fund managers are sometimes compensated based on the amount of capital pooled by the venture capital fund, rather than the return on investment generated. As a result, fund managers may be more inclined to take on higher levels of risk than other VC investors are comfortable with.
3. Becoming a Venture Capitalist
3.1. Starting a VC Fund
In the following section, we’ll go through the key components every aspiring fund manager should define in order to establish a successful venture capital fund. Each of these points should work in synergy, while the fund itself should have a clear point of differentiation when it comes to approach to investing.
Established Track Record
Having an adequate background is one of the most important things for building quality relationships with limited partners. If you’ve already run an accelerator program, or collaborated with entrepreneurs, that is certainly a plus. You’ll also need to demonstrate a comprehensive understanding of the venture capital industry.
Have you been a startup founder yourself? Do you already have previous investing experience? If answers to these questions are positive, this is to your advantage. Do your best to communicate your history of success, credibility, and competitiveness with limited partners, as it’s crucial for building mutual trust.
VC Fund’s Mission and Investment Thesis
Ask yourself the following: why does the industry need your VC fund? What is your main motivation for establishing it?
Each successful VC fund has a point of differentiation. Thus, try to clearly define the purpose and principles of your fund; it may be backing small businesses in a specific geographic area, supporting technology-driven startups that disrupt traditional finance, or providing capital to companies that implement AI in healthcare.
Being authentic and having a clearly defined mission and vision will help you attract both startup founders and investing partners. Based on all of this, as well as your previous track record, you’ll be able to develop an investment thesis. Ideally, the investment thesis of your VC fund will evolve at the same pace as the focus industry.
For every fund manager, it is imperative to have a sufficient flow of relevant early-stage companies to invest in. There’s a variety of ways based on which fund managers generate the deal flow:
- Having an established network of connections with research centers or educational institutions
- Running a startup accelerator or incubator program
- Using tools like Motherbrain to identify promising startups
- Building the VC fund’s brand through marketing activities to motivate companies to reach out themselves
VC Fund’s Operating Model and Strategy
The first step toward building your fund’s strategy is analyzing other VC funds in the same industry, and adapt the model according to the most common practices. This will help you:
- Build an approach to fund size and capital allocation
- Define the number of startups to invest in, and the portion of ownership in each
- Develop a fee/carry structure, co-investing roles and rights
You should also consider getting legal guidance on necessary tools and infrastructure to make sure your fund is compliant with regulatory requirements.
Satisfying Limited Partners’ Interests and Ensuring Their Commitment
It is essential to ensure that your limited partners can commit enough time to your venture fund, as it will be a long-term relationship. In addition to time commitment, offering financial incentives such as a hurdle rate, which is a minimum rate of return, can motivate VC investors to back the project. Typically, limited partners expect at least 1% of the VC fund size.
3.2 Starting a VC Firm
When considering starting a venture capital (VC) firm, the first thing that comes to mind is likely the cost of formation. However, estimating the formation costs of a VC firm is challenging since it depends on several factors, including its size, scope of activities, and location. These costs can range from $5,000 to as much as $1 million.
Although choosing a name for your VC firm may seem like a minor task, it should reflect the firm’s focus and mission. Make sure to come up with something memorable and check the availability of a web domain for it.
Apart from branding, there are several key steps involved in establishing a VC firm. The first of these is creating a business plan. Putting all essential details on paper will help everyone involved fully understand the VC firm’s strategy and roadmap. Additionally, the business plan will be used as a presentation tool when forming partnerships with other VC investors or institutions.
The business plan typically begins with a summary of the key details, followed by a VC firm profile overview that clarifies whether the company focuses on specific industries, startup development stages, or particular geographic locations.
It should also include customer and industry analyses. The former should address targeted startups and their specific characteristics, from operational structure to CEO personas. The latter should focus on the size of the industry in which startup companies operate, what factors affect that industry, and so on.
Next, a competitive analysis should be conducted. Are there similar VC firms operating in your scope of interest? What are the primary reasons and industry gaps that your VC firm will fill? Having good answers to these questions puts you on a solid path.
Finally, it is crucial to determine and thoroughly describe the processes behind daily operations. Define the needs of your staff, create a projected timeline of the VC firm’s progress, and outline what you plan to achieve in the short and long term. This will help you determine the financial requirements, including costs and expenses, as well as the way your VC firm will generate profits.
If your VC firm is going to be located in the United States, you will need to choose an appropriate legal structure for the business entity and register with the Secretary of State. The most common legal structures are Limited Liability Company (LLC), Sole proprietorship, Partnership, C Corporation, and S Corporation. Before making a decision, consider the advantages and disadvantages of each business entity structure.
In contrast to venture funds that are usually formed as limited partnerships, VC firms are usually structured as LLCs.
Taxation and Banking
If your VC firm will have employees, you’ll need to register the company with the Internal Revenue Service (IRS) to obtain an Employer Identification Number (EIN). The EIN is required by banks to open your business banking account and serves for the IRS to track your tax payments.
Next, select your bank and establish a business account. The process of opening a bank account is straightforward, but requires you to submit documents such as your VC Firm’s Articles of Incorporation, which you obtain during the legal entity formation process.
Business Credit Card, Licenses, and Insurance
To separate your VC firm’s expenses from your personal expenses, you will need to obtain a business credit card, either from a bank or a credit card company.
Your VC firm will require various licenses to operate, such as the securities license. This license will enable your business entity to engage in actual investment activities. To obtain the license, prospective fund managers must pass the Financial Industry Regulatory Authority’s (FINRA) qualification exam, called Securities Industry Essentials (SIE).
Next, find an insurance agent who can recommend an insurance policy you will need to operate a venture capital firm. Different types of insurance are required depending on the state where your business operates, including general liability, workers’ compensation, commercial property, business interruption, or professional liability insurance.
Software & Equipment
Chances are you will need some software solutions to help you track and manage your investments. There are various tools specifically designed for VC and deal flow management.
Depending on your circumstances, you may need to purchase or lease office equipment necessary for running a VC company.
3.3. A Closer Look at VC Firm’s Associates and Partners
The venture capital industry is growing rapidly, leading to increasingly complex structures and hierarchies within VC firms. General partners are responsible for overseeing the firm’s operations, while hiring full- or part-time associates to take on various roles and responsibilities.
With so many types of VC associates, it’s important to understand their different scopes of specialization, roles, and responsibilities. Here, we’ll explore five of the most common types of VC associates and what they bring to the table.
Operating Associates are a category of VC associates that work closely with the startups within the portfolio. These associates often specialize in fields such as marketing and advertising, product development and design, or finance.
Their main role is to help startups enter the market or make preparations for the next milestone in their roadmap. Operating associates are typically junior- to mid-level members of venture capital firms and are sometimes formally titled as analysts.
Board Associates, on the other hand, are mainly focused on improving the governance, management, and strategy of the startup company. They actually become members of the board in portfolio companies and are sometimes referred to as Non-Executive Directors.
Ideally, board associates are experts in a given industry and have an established network of relevant connections. One of their main functions is to strengthen the relationship between the VC fund and the invested company. Additionally, they regularly perform due diligence and analyze portfolio companies’ business plans. These are typically senior members of the VC firm.
A VC firm may establish a relationship with professionals focused on generating funds. This is especially true when VCs want to access a broader network of investors. In many cases, they start out as a contractor in a VC firm, and later become general partners after the fund has been closed successfully.
Deal-Sourcing Associates play a critical role in introducing investment opportunities to the VC firm. They usually have a well-established network of connections in a particular industry and are often startup founders themselves, but they can also be angel investors.
Instead of performing due diligence and analyzing deals, they focus on providing a regular deal flow. In return, they receive cash compensation in the form of a carry. Deal-sourcing associates can be senior or principal VC firm members, along with the general partner.
Sometimes, they formally serve as an Entrepreneur in Residence (EIR) – a highly experienced former CEO of a successful startup that contributes to the growth acceleration of the VC firm.
Business development associates are responsible for increasing awareness about the VC firm in a targeted industry or community. A VC firm may specialize in a specific region, technology, or business vertical. Biz-Dev associates’ role is to present the VC firm at important events and introduce it to key individuals in the industry.
It’s important to note that many VC firm associates are engaged only part-time and do not rely on venture capital as their primary source of income. The different types of VC associates have varying responsibilities, but each plays a critical role in the success of the VC firm and its portfolio companies.
Having an MBA (Master of Business Administration) degree is a common trait among most venture capitalists. In addition to having relevant experience in private equity or investment banking, aspiring VCs are expected to have a solid education background. In the United States, Stanford and Harvard University are known for providing quality MBA programs.
3.4. How to Create an LP pitch deck
A Limited Partner (LP) Pitch Deck is a crucial tool used by venture capital firms to raise money from limited partners or institutional investors. This slide presentation outlines essential information about the VC firm, including its strengths, investment thesis, and plans for fundraising and future returns.
To create an effective LP pitch deck, it must be concise and clear. Today, potential limited partners only have a few minutes to review the slides, so it’s crucial to make every point count. In addition, the deck must include adequate legal disclaimers and align with LPs’ standards and expectations.
Let’s go through key points each LP deck has to cover:
The first slide should clearly define the VC firm’s mission and vision in a few sentences or bullet points. This should include the firm’s investment thesis, team’s background, and strategy. It’s also essential to present a unique value proposition for the firm that differentiates it from similar partnerships.
This could be a market gap identified by the VC firm’s team or an untapped local area. It’s important to educate investors about market opportunities, but the information should be
presented in a simple and straightforward manner.
It is preferable that the introductory slides showcase all members of the team and highlight their qualifications and credibility. Doing so will help to establish trust with potential investors.
Portfolio, Deal Sourcing and Investment Process
Use slides to showcase startup companies in the VC firm’s portfolio, the current fund size, the number of investments, the target startup ownerships, and the number of exits. It’s crucial to explain where the deal flow comes from and how it will continue in the future.
This section should also describe the decision-making process behind selecting startups to invest in, preferably using graphic representations and diagrams. This will demonstrate to potential limited partners that your company has a sophisticated process of selection.
Track Record and Case Studies
Each quality pitch deck should include data that illustrates the performance of investments so far. It should highlight previous successes and recapitulate the years of experience in investing, results of coaching and advising you provided to invested startups, and preferably – financial return metrics. A metric commonly used for presenting investment returns is Multiple on Invested Capital (MOIC), sometimes called Equity Multiple – a total value of investment performance or shares in the fund relative to initial investment amount.
Also, fund managers should present the ways in which they’ve contributed to startup growth and made a positive impact.
Fee Structure and Projected ROI
This section of the pitch deck is dedicated to informing potential limited partners of their commitments to the fund, and expected returns.
It should provide details on the carry fee that is paid to general partners (a common percentage is 20%), as well as management fees for administrative services (usually around 2%).
To show that investments are to be worthwhile, the projected Return of Investment (ROI) should be included too. Limited partners usually expect a three to five times greater return on the initial invested capital.
4. Pros & Cons of Venture Capital
4.1. Benefits of Entering the VC Industry
Acquiring insights on what it takes to build a successful business. People that work in the VC industry are able to witness the complete cycle of startup development; from initial idea, to fundraising, generating first revenues, all the way to becoming profitable. By performing due diligence, venture capitalists get to analyze business models, founders and customers, products and markets, supply chains, and so on. This allows them to understand the fundamentals of successful businesses.
Venture capital is hard to disrupt. Compared to other industries, venture capital is fundamentally tied to human cooperation and relationships.
High revenues and excellent work-life balance. In contrast to other professions, venture capitalists earn way more. Also, since the process of investing is a long-term pursuit, there will be few occasions where VC professionals need to complete the tasks urgently.
Developing innovation skills. Venture capitalists are known to support startups that are developing groundbreaking products, services, or technologies, which allows them to observe market trends and customer behavior changes before they become widely adopted. By focusing on building solutions that don’t exist yet, startups have the potential to generate higher profits than those that simply improve upon existing products. Furthermore, being involved with innovative companies fosters a forward-thinking mindset that can anticipate what will be popular in the next 5 to 10 years.
Further career development and building professional networks. Experienced venture capitalists have analyzed countless startup companies and gained valuable insights into what it takes for a startup to achieve unicorn status. If they decide to transition to a role within a startup company, they can leverage this knowledge to make critical contributions to the company’s success. Additionally, VCs frequently meet with the most innovative individuals in the world – startup founders. This provides an opportunity to build a network of highly skilled professionals across a range of industries.
4.2. Drawbacks of VC Industry
Investing in venture capital comes with several risks that investors should be aware of. Here are some of the most significant ones:
Possibility of losing the entire investment: An investment in a startup can become illiquid, meaning that a liquidity event such as a sale or Initial Public Offering (IPO) may not be possible due to securities legislation, the lack of an active market for the company’s shares, or the company’s failure to generate sufficient revenue for an exit strategy. With a long-term investment horizon, investors may be unable to sell their securities until an IPO occurs or they find a buyer, adding to the risk. It is therefore essential to consult with a financial advisor regarding financial goals and investment portfolios.
Weak chances of advancing to the senior position. The top management in VC firms usually consists of one or two individuals. Since it takes years, or even decades to make profits or earn a carry, there’s a huge possibility of not being able to advance in the hierarchy for a long time – especially without a proven track record, owned by VC Firm leaders. Have in mind that many VC firms have no interest in introducing new general partners; they’d rather split the return among fewer parties.
Majority of gains go to minority of team members. Working in a VC firm can make you spend years earning money for others. Even if you’re paid fairly high, the management company can get 99% of all the returns, regardless of the fact that you have sourced a startup that became extremely successful.
The VC industry is fiercely competitive. Although it is not difficult to identify promising startups, especially with previous experience, the real challenge is to win and source the best deals. Only a few venture capitalists can find and source more than one unicorn in a couple of years. It takes a significant effort to convince founders to choose your VC over other, more established firms.
Unforeseeable difficulties are common in the VC industry. There are three types of potential barriers that can hinder long-term returns. The first type is related to economic factors, such as a recession. The second type is related to legislation and government regulations, particularly if a VC firm deals with neobanks or crypto-related companies. The third potential risk is related to intellectual property and possible patent infringements.
Investors need to be accredited. Investors who wish to engage in private offerings, including VC investments, must be accredited according to the Securities and Exchange Commission (SEC). This requirement is intended to protect investors by limiting such offerings to individuals who can absorb potential losses and manage the potential illiquidity of VC assets. To meet the criteria for accredited investor status, an individual must have earned more than $200,000 in each of the last two years, or have a net worth of over $1 million.
5. Legal, Regulatory, and Taxation Implications
5.1. Legal Aspects of Venture Capital
Venture capital funds (and private funds in general) are regulated by a number of federal laws that define how VCs raise financial resources, set up a legal entity, and provide services to other investors (limited partners). Venture capital is under the jurisdiction of the Securities and Exchange Commission (SEC).
- No more than 20% of fund’s capital is invested in non-qualifying assets, which include debt, secondaries, fund-of-fund investments, Initial Public Offerings, or digital assets.
- A maximum of 15% of the fund’s size should be based on borrowing; all leveraged debts need to be repaid within 120 days
- The fund represents to existing and potential investors that it follows a venture capital strategy – which includes aspects such as stage of investment and industry
- Limited partners are able to cash out of the fund only in “extraordinary circumstances”.
- The fund must not be publicly offered and needs to have less than 100 owners, all of which are accredited investors
- In case owners are not accredited, the fund must not manage more than $10 million and needs to have fewer than 250 owners
- It can be any fund not publicly offered, but all investors need to be qualified purchasers
- The fund can have a maximum of 1,999 investors
Provided that funds meet above criteria, they are exempt from the requirement to register with the SEC, in contrast to mutual funds or closed-end funds. The latter are allowed to collect investment capital from the general public, but are subject to extensive compliance requirements.
Since the majority of VC funds are not required to register with the SEC, more regulatory
requirements are imposed on VC fund managers. Different regulations apply based on the size of fund manager’s assets under management:
- If size of assets under management does not exceed $25 million, the fund manager is qualified as a small adviser and is regulated by the state regulator
- If size of assets under management is between $25M and $100M, the fund manager is qualified as a mid-size adviser and is regulated by the state regulator or SEC
- If size of assets under management exceeds $100 million, the fund manager is qualified as a large adviser and is regulated by the SEC
Depending on circumstances, fund managers can also qualify as exempt reporting advisers and avoid regulatory requirements:
- In case fund manager strictly advises private funds with total assets under management of less than $150 million
- In case fund manager strictly advises venture capital funds
However, the exempt reporting advisers are still required to complete the Form ADV, containing information about the fund manager and business operations details. Both categories, registered and reporting advisers, can be subject to examination by both the SEC and state-level regulators.
When it comes to SEC-registered fund managers, they are obligated to file Form PF in case their assets under management exceed $150 million. This reporting document provides all the information about the size of the fund, liquidity, and number of investors.
Fundraising by venture capital funds is regulated by Regulation D that outlines how the private capital is raised – specifically through Rule 506(b) and Rule 506(c). According to this, VC funds are able to raise unlimited capital, provided that investors are accredited. On the other hand, Regulation S defines how companies can sell their shares to investors outside the United States.
5.2. Taxation Aspects of Venture Capital
VC funds are in most cases structured as limited partnerships. As such, these legal entities fall into the category of “pass-through” entities, which means the business itself is not liable for income taxes, but the liability is passed over to each business owner – in this case, general partners (GP), and limited partners (LP).
The taxation amount depends on multiple factors, such as the timespan during which the funds hold an investment prior to liquidating it, the gross income, and the type of income reported.
What Gets Taxed in a VC Fund?
Realized Gains. Both general and limited partners are required to pay taxes on their share of VC Fund’s income. If the VC fund was holding assets for less than three years, the returns associated will be treated as a short term capital gain, with a maximum tax rate of 37%. In case the fund was holding the assets for more than three years, the associated returns on the investment are treated as long-term gains and will be subject to a maximum tax rate of 20%. The exact tax rate depends on the adjusted gross income of each partner.
Management Fees. The net income generated from general partner’s management fees is subject to standard income tax rates in the United States.
Carried interest / Carry. A fixed percentage of VC funds profits (known as “Carry”), paid to general partners as a compensation for providing ROI to limited partners, is considered by law as a return on investment and taxed as a capital gain.
The Internal Revenue Service (IRS) requires both general and limited partners to report their profits or losses using a Schedule K-1 IRS form. In case the invested company closes down, implying that there is no return on the investment, the general partners are able to write off that investment.
6. Venture Capital and Web3
6.1. How VC Financing Works in Crypto and Web3 Industries
Venture capital financing in the Web 3.0 industry is rather similar to traditional VC funding, except for one detail that makes a huge difference – VCs are investing in blockchain and cryptocurrency projects. Bearing in mind the regulatory guidelines that are still developing, as well as the need for longer investment lock-up periods, venture capital in the Web3 space implies even more risk.
Another important aspect is the fact that Web3 companies rely on new, more “democratic” ways of raising capital, such as Initial Coin Offerings (ICO), and more recently Initial DEX offerings (IDO). Additionally, the emergence of Decentralized Autonomous Organizations (DAO) allows startup founders to stop relying on VCs and traditional fundraising models, and obtain capital from the investment vehicle run by the community.
These Web3-powered models of raising capital were somewhat controversial in the past and had their own setbacks, but the development of more sophisticated frameworks and tools made possible for the concepts not to be abandoned.
Nevertheless, an increasing number of VC funds and institutional investors are showing interest in web3, crypto, and blockchain-related businesses. This surge in interest is largely driven by the high potential for growth and disruption, making them attractive opportunities for investors looking to diversify their portfolios and capitalize on the potential for high returns.
6.2. How Web3 Can Disrupt Venture Capital
Venture capital firms do not solely provide financing to startups; they also offer an array of additional services that are essential for their success. These services include legal support, consulting, marketing, recruiting, and more.
The web3 startup ecosystem operates on unique community-driven mechanisms, lacking a central authority to make decisions. These mechanisms rely on community voting recorded on the blockchain, resulting in a paradigm shift for traditional venture capital firms. To remain relevant in the web3 era, venture capitalists must engage more actively with these communities to partake in investment opportunities.
In essence, the web3 revolution is challenging venture capitalists to rethink their strategies and adapt to new market dynamics to remain competitive. Only those who embrace these changes and leverage innovative approaches will succeed in this rapidly evolving landscape.
The traditional venture capital model must demonstrate its value proposition for emerging web3 projects and present a compelling case for why it is superior to community-driven, decentralized fundraising models such as investment DAOs. To adapt, VC firms are already exploring alternative models, such as transforming into DAOs themselves. Another example of web3 disruption is the Unique.vc platform, enabling investors to create or join VC funds and leverage blockchain technology to manage them.