On a regular basis, tech publications are awash with stories of startups raising funding from investors, who more often than not, are venture capitalists. This type of funding is called venture capital, and it usually fills a void that most types of financing dont. But like every investor, VC firms have to make returns off their investment. So how do they do it? In this latest article of CEO East Africa explains, we will break down how a typical VC firm makes these returns. But first, lets understand what venture capital is.
What is venture capital?
Venture capital is a type of private equity investment where funds are provided by investors to startups believed to have long-term high-growth potential. These investments are usually high-risk, but they can also offer the potential for above-average returns. A venture capitalist not only provides capital to start-up ventures but also takes an active role in managing them. They provide strategic planning, introduce networking opportunities, and may even influence company direction to ensure a substantial return on investment.
History of Venture Capital
Venture capital as we know it today has its roots in the post-World War II era. The first venture capital firm, American Research and Development Corporation (ARDC), was established in 1946 by Georges Doriot, the “father of venture capitalism.” However, it was the establishment of Draper, Gaither and Anderson in 1958 that marked the true beginning of institutionalized venture capital. This firm was the first to raise a venture capital fund, essentially pooling investments in a variety of companies.
The industry grew slowly until the 1980s, when venture capitalists fueled the tech and biotech revolution. The success of companies like Apple, Genentech, and others attracted more interest in venture capital, leading to an industry boom. Today, venture capital is a prominent source of funding for startups, particularly in high-tech industries.
Venture Capital vs. Other Forms of Financing
Venture capital is distinct from other forms of financing in several ways. Unlike banks and other lenders, venture capitalists do not seek repayment of their investment. Instead, they exchange their money for a stake in the company, hoping the company will become successful and their equity will become valuable.
In contrast to private equity, which generally invests in mature companies through leveraged buyouts, venture capital is focused on young, high-growth companies. While angel investors also invest in early-stage companies, they typically invest smaller amounts than venture capitalists and do not take as active a role in company operations.
Why Startups Turn to Venture Capital
Startups often turn to venture capital for several reasons. First, VC funding can provide a significant amount of money that a startup needs to grow rapidly. Secondly, venture capitalists often offer expertise and connections that can help a startup succeed. They can provide guidance on strategy, hiring, marketing, and other key aspects of business.
Moreover, securing venture capital can enhance a startup’s credibility, making it easier to attract other investors, partners, and customers. Lastly, unlike bank loans, venture capital does not have to be repaid, allowing startups to focus on growth rather than debt repayment.
How Do VCs Make Money?
Venture capital (VC) is a form of private equity investment where firms provide capital for early-stage or emerging companies that demonstrate high growth potential. These firms, typically known as venture capitalists, play an integral role in fueling innovation, driving competition, and helping small businesses scale up to meet market demands significantly. On the outside, the process appears rather simple—venture capitalists invest massive sums into startups, hoping that one day, these companies will make it big and return the favor with skyrocketing profits.
But one question that often pops up in conversations is—how do venture capitalists make money? After all, betting on untested companies seems like a considerably high-risk strategy. Although the venture capital industry remains highly volatile—where losses are repugnant and gains can be astronomical—venture capitalists have three primary ways of making money:
1. Carried Interest on their investments
2. Management fees
3. Profits generated from lucrative deals
MadMan on a Mission: TROI Media's Joshua Kamugabirwe’s Vision for a More Agile, Accountable, and African Advertising FutureLet’s examine these methods in further detail to understand how venture capitalists turn a profit amidst high risk and uncertainty.
- Carried Interest
Carried interest, also known as “carry,” contributes significantly to how venture capitalists make money. It refers to the percentage of a fund’s profits that the VC firm’s partners get to keep on investments made through the fund. Most VC firms typically collect about 20% of the profits from the private equity fund as carried interest.
For instance, suppose a VC firm invests $10 million in a startup. Over time, if that investment grows to be worth $50 million, the firm has made a profit of $40 million. The VC firm is entitled to 20% of this profit as carried interest, which amounts to $8 million. This amount is then distributed among the venture capitalists involved in the fund based on their agreed-upon percentages.
Recall that the remainder 80% of the profits, goes to the limited partners (LPs). LPs can range from pension funds, institutions, university endowments, among others, who have invested in the fund. In the example above, the LPs would receive $32 million out of the $40 million profit.
Carried Interest, therefore, forms a significant incentive for venture capitalists to ensure the success of the startups they invest in—it is literally their share of the pie. However, this is also a high-risk proposition, as venture capitalists only receive carried interest if the fund makes profits. In cases where investments fail to generate expected returns or end up in losses, the VC firm does not receive any carried interest at all.
- Management Fees
In addition to the profits from their investments, venture capital firms also receive management fees. These fees are extracted annually as a percentage of the fund’s capital commitments and are meant to cover the operational expenses of managing the fund.
Usually, the management fee for a VC firm ranges around the 2% mark. For example, if a VC fund has raised a total sum of $100 million, the VC firm would receive an annual management fee of $2 million. This money is used to pay for office rent, salaries of employees, traveling expenses, legal fees, and other costs associated with running the fund and making potential investments.
Note that management fees are unrelated to the performance of the company in which the VC firm has invested. As a result, venture capital firms receive management fees regardless of whether the funds they invest yield profits or not. However, as the lifespan of a VC fund progresses—usually around ten years—the operational budgets tend to decrease, and consequently, the management fees may also reduce.
Though management fees provide a steady stream of income for VC firms, they are generally insufficient to cover the costs involved in managing a fund in the long run. Consequently, the primary source of significant monetary gain for a VC firm remains the carried interest from successful investments.
- Profits from Successful Deals
Venture capitalists also make money from the profits generated when their portfolio companies are either sold or go public via Initial Public Offerings (IPOs).
When a VC firm invests in a startup, it becomes a shareholder in that firm, owning a certain percentage of shares. If the startup achieves success and is later acquired by another company or goes public, the VC firm sells its shares and makes a profit.
For instance, imagine a VC firm investing $15 million in a startup for a 25% stake. If the startup’s value surges to a whopping $200 million in an acquisition deal, the VC firm’s stake now stands at $50 million—a $35 million profit. As with carried interest, this profit would be divided between the firm’s partners and its limited partners according to their respective agreements.
The immense profits from successful deals like these often cover the losses from failed investments, allowing VC firms to net a tidy profit and offer appealing returns to their limited partners. However, striking such lucrative deals is rare and unpredictable, with only a small fraction of investments typically becoming “home runs.”
While the prospect of making enormous profits through venture capitalism is appealing, it’s essential to understand that the VC industry is fraught with risks and uncertainties. Most startups fail to deliver the anticipated returns, and as a result, VC firms often lose significant sums. But when an investment pays off, it can generate immense profits that cover multiple losses, thereby maintaining the allure of venture capitalism.
In essence, in the arena of venture capitalism, the returns heavily skew towards a small fraction of investments that provide exponential gains. It’s the constant pursuit of these “unicorn” startups—valued over $1 billion—that keeps the venture capital wheel turning, despite the inherent risks and sporadic hits and misses.
So, venture capitalists make money via carried interest, management fees, and profits from successful deals. But it’s important to note that the journey to profitability for VC firms is often long, windy, and fraught with risk. However, the potential for sizeable returns propels these firms to bet on the next big thing, fuelling entrepreneurship, prosperity, and innovation in the bargain.
