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A Beginner’s Guide to Venture Capital Funds
You have heard of venture capital funds before, but do you know how they work? Let's break it down to basics, from fundraising to value creation.
Venture capital funds are investment vehicles that pool capital from institutional investors, high-net-worth individuals, and sometimes even corporations, to invest in early-stage, high-growth companies.
For investors interested in investing in a venture capital fund, sometimes the process of how they work can be opaque. Here’s how venture capital funds typically work, from investment strategies to value calculations.
The Investment Strategy
First, a venture capital fund will develop an investment strategy (sometimes called an Investment Plan). This may include a focus on specific industries, geographic regions, or stages of development. The development stages of startups are particularly important and most often consist of the following:
Pre-Seed – Startups are generally still building product, ideating concept, determining market fit and may have a small user base.
Seed – Startups have demonstrated that the business is viable and have some early metrics to prove that there is demand for product. Revenue and signs of growth are becoming clear and key personnel are in place within the business.
Series A – This is the time to scale up the business, but significant investment is required to grow. The business by now has a working product, a brand, a loyal customer base, and significant revenues with a potential to expand.
Series B – The startup has grown into a real company with a higher valuation to prove it. The business concept is well and truly validated. Series B is for mature companies who are looking for additional funds to reach the next level and meet the demands of a growing customer base, and possibly expansion into new markets, products, or acquisitions.
For example, an early-stage VC Fund might aim to invest in fintech or sustainability focused businesses within Australia that are in the pre-Seed through to Series A stage of their lives.
How VCs Fundraise
Venture capital funds raise capital from investors, who become limited partners in the fund. The general partner is responsible for ensuring the fund operates in accordance with the Partership Deed (a document outlining the rules of the fund). The general partner is also responsible for engaging with service providers to the partnership, including the fund manager (that is normally a related entity or associate of the general partner). The fund manager makes investment decisions on behalf of the fund in accordance with the Investment Plan. Limited partners commit to providing capital to the fund over a period of several years, typically seven to ten years.
However, as some funds may seek to deploy capital over the initial few years, they will not ask for all the capital upfront. Venture capital firms may call upon the remaining committed capital from investors only as they need it. Doing so prevents the cash from sitting in a bank account and diluting returns. Instead, this allows investors to continue to invest their money in other (generally liquid) areas if they choose to do so. However, importantly, investors need to remember their obligation to make the future capital payments when called upon or risk becoming a defaulting limited partner.
How VCs Source Deals and Enact Due Diligence
After securing enough limited partners, venture capital firms will then begin sourcing potential investment opportunities for the fund through various channels, including referrals, networking, and industry events. Once a potential investment opportunity is identified, the fund will conduct due diligence to assess the potential of the startup and its founders.
Making an Investment Decision
After completing due diligence, the venture capital fund will decide whether to invest in the startup. If the investment is approved, the fund will negotiate the terms of the investment, including the valuation of the startup and the amount of equity the fund will receive.
These due diligence periods prior to an investment decision are very resource heavy and often involve significant research on the startup founders, the market and competition, product viability, and whether a mutually beneficial long-term relationship can be created between the two parties.
Managing the Portfolio
After making an investment, the general partner/manager actively manages the portfolio of investments by providing guidance and support to the startup's management team, monitoring performance, and helping the company to grow and scale.
This is a resource heavy phase of the venture capital fund’s life. It may involve members of the team sitting on the board of the portfolio companies to provide guidance and report to limited partners about the development of each company.
Venture capital investments are typically illiquid, meaning that it may take several years before the investment can be sold. However, the venture capital fund will typically have a target timeline for exiting its investments, which may include a sale to another company, an initial public offering (IPO), or a merger and acquisition (M&A) deal.
Venture capital funds typically charge fees to investors, including a management fee and a performance fee. The management fee is a percentage of the committed capital that is paid to the general partner/manager to cover the costs of running the fund. The performance fee, also known as the carried interest, is a percentage of the profits that the general partner/manager receives once the LPs have received their initial investment plus a minimum ‘hurdle’ amount (typically 8% p.a. on capital invested) back.
Overall, venture capital funds play an important role in the start-up ecosystem by providing capital and support to early-stage companies. From an investor’s perspective, venture capital funds can be utilised for a variety of reasons:
Investor/Limited Partner tax incentives: In Australia, the early-stage venture capital limited partnership (ESVCLP) program provides tax incentives for investing in early-stage venture capital activities through eligible funds.
Diversification: Including venture capital in a diversified investment portfolio can help spread risk across multiple asset classes. Venture capital investments tend to have a high risk and high return profile, which can help to balance out other investments in the portfolio.
Exposure to innovation: Venture capital investments provide exposure to cutting-edge technologies and disruptive business models that are not typically available through traditional investments.
Alpha generation: Venture capital investments have the potential to generate alpha, or returns above the market average. This can be attractive to investors who are seeking to outperform traditional investment benchmarks.
Strategic investments: Venture capital can be used as a strategic investment tool to support specific investment themes or initiatives.