Who Are They and What Do They Do?

Venture Capital Structure

High-net-worth individuals (HNWIs), insurance companies, pension funds, foundations, and corporate pension funds may pool money in a fund controlled by a VC firm. The venture capital firm acts as the general partner (GP), while the other companies or individuals are LPs. All partners have part ownership of the fund.

The roles within a venture capital firm vary, but they can be broken down into roughly three positions:

• Associates: These individuals usually come to VC firms with experience in either business consulting or finance and, sometimes, degrees in business. They tend to analyze business models, industry trends, and sectors. They also work on a firm’s portfolio. Although they do not make critical decisions, associates may introduce promising companies to the firm’s upper management.
• Principals: A principal is a midlevel professional. They usually serve on the boards of portfolio companies and ensure that they run without significant hiccups. Principals are also responsible for identifying prospects for VC firms and negotiating terms for acquisition and exit. Principals are on a “partner track” that depends on the returns they generate. 
• Partners: Higher-profile partners primarily identify areas or specific businesses to invest in, approve deals (whether investments or exits), occasionally sit on the board of portfolio companies, and represent their VC firms.

Venture capitalists must follow regulations in conducting their business. The U.S. Securities and Exchange Commission (SEC) regulates private-equity firms and venture capitalists.

Venture capital fund managers are paid management fees and carried interest. Depending on the firm, about 20% of the profits are paid to the company managing the private equity fund, while the rest goes to the LPs invested in the fund. General partners are usually due an additional 2% fee.

History of Venture Capital

The history of individuals and firms investing in high-risk and high-reward ventures is centuries old—it’s hard to imagine the history of shipping, whaling, and colonialism without it. However, the first modern venture capital firms in the United States started in the mid-20th century. Georges Doriot, a Frenchman who moved to the U.S. to get a business degree, became an instructor at Harvard Business School and worked at an investment bank. In 1946, he became president of the American Research and Development Corp. (ARDC), the first publicly funded venture capital firm.

ARDC was remarkable in that, for the first time, a startup could raise money from private sources other than wealthy families. Before, new companies generally looked to the likes of the Rockefellers or Vanderbilts for the capital they needed to grow. ARDC soon had millions in its accounts from educational institutions and insurers. ARDC alums founded firms such as Morgan Holland Ventures and Greylock Partners.

Startup financing began to resemble the modern-day venture capital industry after the passage of the Investment Act of 1958. The act enabled small business investment companies to be licensed by the U.S. Small Business Administration (SBA), which had been established five years earlier.

By its nature, venture capital invests in new businesses with excellent growth potential but enough risk to be sidelined by banks with various requirements about what kinds of ventures they can support with loans. Fairchild Semiconductor, one of the earliest and most successful semiconductor companies, was the first venture capital-backed startup, setting a pattern for venture capital’s close relationship with emerging technologies in the San Francisco, California, area.

Venture capital firms in that region and period also established the standard practices that are still used today. They set up limited partnerships to hold investments, with professionals acting as general partners. Those supplying the capital would serve as passive partners with more limited control. The number of independent venture capital firms increased in the following decade, prompting the founding of the National Venture Capital Association in 1973.

Venture capital has since grown into a hundred-billion-dollar industry. Today, well-known venture capitalists include Jim Breyer, an early Facebook (META) investor; Peter Fenton, an early investor in X (then Twitter); and Peter Thiel, co-founder of PayPal (PYPL).

VC Expected Returns on a Deal

Venture capitalists usually invest in startups with the expectation of making a significant return on their investment. The structure of the expected return is based on the high risk associated with investing in early-stage companies and the potential for high rewards if the startup succeeds.

VCs typically aim for a return of at least 10 times their initial investment over five to seven years. If a VC invests $5 million in a startup, it would expect to receive at least $50 million upon a successful exit, such as an acquisition or an initial public offering (IPO).

However, VC returns often follow a power-law distribution, where a small number of highly successful investments (known as “home runs”) generate the most of a fund’s returns. In contrast, others break even or post losses. To achieve their target returns, VCs construct a portfolio of investments, diversifying across different sectors, stages, and geographies. They expect that out of a typical portfolio of at least 10 to 20 investments, something like the following will occur:

• One to two investments will be “home runs,” returning more than 10 times the initial investment.
• Two to three investments will have moderate success, returning two-and-a-half to five times the initial investment.
• Four to five investments will only return the initial capital or generate a small profit.
• Four to five or more investments will fail, resulting in a partial or total loss of the invested capital.

By diversifying their portfolio and aiming for a few home runs, VCs can achieve their overall fund return targets of 20% to 30% annually, even with a high failure rate among their investments.

Of course, VC returns are not guaranteed and are subject to various risks, such as market conditions, competition, and execution challenges faced by the startups they invest in. In addition, VC investments are illiquid since investor capital is typically locked up for several years until an exit opportunity arises.

Example of a VC Deal

Suppose ABC Inc., a tech startup, has been growing rapidly and is looking to raise $5 million in Series A funding to expand its team, invest in product development, and scale its marketing efforts.

The founders of ABC pitch their business to several venture capital firms and receive interest from VC firm XYZ. After due diligence and negotiations, XYZ agrees to lead the Series A round and invest $3 million, with other investors contributing the remaining $2 million.

The terms of the deal are as follows:

1. Valuation: Startup ABC is valued at $20 million pre-money (before the investment). With the entire $5 million investment, the post-money valuation is $25 million.
2. Equity: VC firm XYZ receives 12% of the company’s equity ($3 million divided by $25 million) in Series A preferred stock. The other investors collectively receive 8% ($2 million divided by $25 million), leaving the founders and employees with the remaining 80%.
3. Board seats: XYZ receives one seat on ABC’s board of directors, giving it a say in major strategic decisions.
4. Liquidation preferences: The Series A preferred stock comes with a liquidation preference, meaning that if there’s a sale or company failure, Series A investors will receive their initial investment back before the common stockholders (founders, employees, future outside shareholders).
5. Milestones and tranches: If the company attains certain milestones, such as revenue targets or product launch dates, the funding may be released in tranches.

After the deal closes, ABC’s founders will use the funds to hire additional software engineers, expand its sales and marketing teams, and invest in new product features. XYZ provides guidance and introduces the founders to potential partners and customers.

As ABC continues to grow, it may raise additional rounds of funding (Series B, C, etc.) at higher valuations, with XYZ potentially participating in these rounds to maintain its ownership stake. The ultimate goal for both the founders and investors is to achieve a successful exit through an acquisition or an initial public offering (IPO), providing a return on investment for the VCs and a payout for the founders and employees.

The Bottom Line

Venture capitalists (VCs) are investors who form limited partnerships to pool investment funds. They use that money to fund startup companies in return for equity stakes in those companies. VCs usually make their investments after a startup has been generating revenue rather than in its initial stage.

VC investments can be vital to startups because their business concepts are typically unproven and pose too much risk for traditional funding providers. While most VC ventures lose money, the profits from their “home runs” should outpace these losses for a fund to be successful.