Venture capital finance has been eloquently outlined by Fred Wilson in his blog. Since I look at this blog as my personal file cabinet, I copied and paraphrased Fred's post here. I hope he doesn't mind, but I wanted to put this somewhere that I could always access his great overview of how venture capital works. If you can refer back to his original post since the comments made by readers are equally informative.
Venture Capital Finance:
If you commit $1mm to a venture fund, you will receive capital calls about once a quarter for anywhere from 3% of your commitment to 10% of your commitment. It takes time for a venture firm to put the money to work and they'd rather leave it in your bank account than have in in their bank account.
Venture investments are generally made in a number of rounds staged out over a three to six year period, even when the venture firm finds an investment, the amount they invest in the company upfront is a percentage of what they will eventually put to work.
So the money flows into venture funds slowly.
The money also flows out slowly. When a company is sold, the proceeds are distributed. Venture investments require long hold periods, typically five to seven years. It's common for a venture fund to have to wait five or six years to make its first distribution. Most venture funds have a ten year life and are often extended a few more years to get all the distributions out.
The low end of acceptable performance for a venture fund is to return two times invested capital to its limited partners (investors). If you put all the money in day one and waited ten years to get 2x back, that wouldn't be a particularly interesting rate of return. It's 8% to be exact, not the kind of return an investor would think is acceptable for a ten year illiquid investment.
But if you map out the cash flows that I described in this post, they look something like this:
So, if you invest $1mm into a ten year fund and get back $2mm, you will likely be earning something closer to 13% than 8% just because the $1mm wasn't tied up in the fund for the entire ten years.
Getting 2x invested capital back is the absolute low end of acceptable performance in a venture fund..
Waiting for years 8, 9, and 10 to get distributions is conservative. You could theoretically get to annual returns of over 40% for a fund that only delivers 2x on committed capital.
Investors want to get the highest absolute returns they can get. And 2x is just not that exciting. I think 3x or better is what it takes to deliver top tier performance.
The returns venture firms get on their investments are called "gross returns". 2x is the lowest attractive return on a venture fund.
A fund has to earn more than $2 investors $2 back due to fees. Managers of the fund take a carried interest on the profits. Fund management takes somewhere between 20% - 30% in fees.
Management fees pay for the costs of running the venture business. Management fees a range from 1.5% per year for large funds to 2.5% per year for smaller funds. They typically tail off after the first five years to much lower percentages to reflect that the work of putting the fund to work is largely over.
The carried interest is only paid on gains. So if they fund makes no money, no carried interest is paid. But if the gains are large, the carry will be large too.
Typical Model used by Union Square Ventures (when they started the fund):
Here's what this $100mm venture fund model produces:
Total Management Fees: $20mm
Total Invested Dollars: $80mm
Total Proceeds on Investments: $322mm
Total Gain on Investments: $242mm
GROSS Multiple: 4x ($322mm/$80mm)
GROSS IRR: 39.2%
Multiple Incl Mgmt Fees: 3.2x
Gain Incl Mgmt Fees: $222mm
IRR Incl Mgmt Fees: 32.9%
Carried Interest Fees: $44mm (20% of $222mm)
NET Multiple: 2.56x
NET IRR: 28.6%
So to make it really simple, a fund needs to get 4x (in this case $322mm on $80mm of invested captial) on its investments to generate 2.5x in distributions to its limited partners.
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