This post is the eighth installment of “Laying Down the Law” – a series where our attorney friends at Troxel Fitch give legal advice for budding entrepreneurs. View the previous post about The First Financing – Friends, Family & Angels here.
Getting money from friends and family is a great way to get your business off the ground. In turn, getting financed by an angel investor is a great way to take your business from a small shop into a legitimate and consistently profitable business. However, some businesses that show immense promise and scalability have an opportunity to take the next step into massive market success. At this point the entrepreneur generally has two choices.
On one hand, the entrepreneur can continue to grow the business organically, using the company’s profits to invest back into the business and achieve new growth milestones. However, this is a slower process, and many times can lead to the company missing out on opportunities to capture a larger piece of market share through faster growth.
Therefore, some companies need an immediate infusion of a substantial amount of cash to achieve more growth in a shorter period of time. This is when venture capital (VC) financing should be explored.
Many entrepreneurs have heard the word “venture capital” or “VC,” but how many entrepreneurs actually know what a venture capital firm is, how it is structured, and how it makes money? It is important to understand these things so that you can better understand what incentivizes VCs, and in turn have a better grasp on what to expect when seeking venture capital financing.
What is a venture capital firm?
Venture capital firms at their most basic level are professional investing companies. Think of it like this: when you are receiving money from friends and family, you are playing amateur ball. Then, when you reach the point where your business is ready for angel investment, you are now a professional, but in the minor leagues. Finally, if and when your company is ready for venture capital financing, you are stepping up to the major leagues.
While many entrepreneurs hear about VC financing regularly, like the real major leagues, very few small companies actually receive VC financing. Many companies that think they are ready for venture financing begin to pitch VC firms and quickly realize that they are not ready for the big leagues.
Understanding how a VC firm is structured and how they make money is essential before trying to raise venture financing, as understanding what incentivizes VCs will better prepare you to have a mutually positive outcome to a venture financing.
How are venture capital firms typically structured?
To begin to understand what a VC’s incentives are, first we will take a deeper dive into how VC firms are actually structured. The specifics of the typical complex, multi-level entity structures used by VC firms are outside the scope of this discussion, so we will stick to the basics.
First, a VC firm does not actually invest its own money. Instead, the VCs go out and raise money from many different institutional investors, including university endowment funds, banks, and government pension funds. These investors are called “limited partners.” The limited partners give the VCs money, which the VCs invest in promising companies. The VCs, on the other hand, generally contribute only their expertise and management services.
Limited partners do not invest money with VCs because they are your buddy; they invest money with VCs because they believe the expertise of the VC will bring them at least a 20 percent return on their investment annually. With this kind of pressure on a VC (without even mentioning what needs to happen for the VCs themselves to make money), you can see why the game becomes much more cutthroat than when you were dealing with family, friends or angels. At this point, it’s all business, and you need to treat it as such.
How do venture capital firms make money?
With the limited partners expecting at least a 20 percent return, where in the world do the VCs make their money? Most VC funds pay the VCs in two ways: management fees and carried interest.
The management fee is the money that pays to keep the VC fund operational throughout the life of a VC fund (typically 10 years). These fees are typically 2 percent of the total money in the fund. For example, if the fund is for $100 million dollars, the management fees will be $2 million dollars per year.
Carried interest, or carry, is where the VCs make their real money. At the end of the 10-year lifecycle of each fund, VCs must first pay back the limited partners the full amount of their investment. Then, any remaining money is typically split 80/20 between the limited partners and the VCs, respectively. For the sake of clarity, let’s return to the $100 million fund example above. If the fund makes $500 million over the course of the 10-year fund, the VCs will first pay back their limited partners the $100 million they invested. Then, the remaining $400 million will be split 80/20, meaning that the limited partners will share $320 million, and the VCs will take home $80 million.
With this level of profit potential, VCs are inclined to only invest in companies that have the potential to bring in massive returns over the course of the fund. Therefore, unless the VCs can see a potential 10x-30x return on their investment in your company, VC financing is probably not an option for you.
In conclusion, venture financing can be an incredibly powerful tool when the right company finds the right VCs. However, because VCs have to answer to their own investors, they are generally not your friend and are only focused on the bottom line. Further, because VCs must invest in companies that have the potential to make a massive profit, if your company does not have the potential to blow up, it is not the right fit for VC financing. If you are even considering pursuing VC financing, you should seek legal counsel immediately.
Check back in next month as we dive deeper into the VC world, exploring the term sheet (the document that outlines all of the basic terms of a venture financing) and the most negotiated terms.
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