Entrepreneurs are generally frustrated with how difficult it is to raise funds. Much of this frustration is directed toward Venture Capitalists; they seem to fund so few opportunities, their criteria for investment is somewhat mysterious, they have a reputation for tough negotiation and low valuations, etc.The purpose of this note is to give you insight into how a venture capital company works, how its partners are compensated and why they operate the way they do.

Venture capital funds are typically organized as a Limited Partnership (the “Fund” or the “LP”) managed by a General Partner (the “GP”). Putting aside the legal details, the GP is the outside facing group with all the partners, associates, etc. The GP is all the partners and other staff of the VC and is responsible for all management of the fund, for making investment decisions, for supervising the fund’s investments, etc. In order to understand the GPs motivations, it is important to understand their compensation. In general, GPs receive “2 and 20″. Each year, they receive 2% of the total committed capital in the fund as a management fee, and, at the end of the day, they get 20% of the profits generated by the fund after paying back investors. In general, the GP is committed to paying a “preferred return” on the invested capital before getting their share of the profits. A “fund” is not really a collection of cash sitting in a bank; rather it is a commitment by the investors to send in capital when the GP asks for it. Typically, the called for, and invested over 3-4 years and the expectation is that all activity will be complete for that particular fund in 7-10 years.

A few simplified illustrations:
Assume a $50mm fund that has committed an 8% preferred return to investors before they share in the profits. The fund will generate $1mm of fees per year for GP (the partners and the people that work on the fund). Assume that the fund invests $40mm of the committed capital and that all activities are wrapped up at the end of eight years.

Scenario 1: The total return on investments ends up being $80mm after eight years. The total fees drawn by the GP over that period are $8mm. If there was no “preferred return” promised to the investors the allocation of returns would be:
- $80mm total returns
- $48mm paid back to investors first (invested capital plus fees paid in)
- $32mm remaining to split
- The GP would receive $6.4mm (20%) and the investors would get back the balance of $25.6mm. The problem with this outcome is that the GP (management) got a cash payoff in a scenario where the investors actually received returns of something less than 10% per year. That is not an acceptable return for this type of risk. So instead, investors generally require a “preferred return” before management gets their split of the money. In this particular scenario, a 8% preferred return applied to the moment when capital was called for either deals or fees would probably mean that the GP would get nothing after this period of work and the investors would get back all the profits. No one would be very happy.

Scenario 2: The total return on the investments ends up being $120mm. Given that this overcomes the preferred return commitment the allocation of returns would be:
- $120mm total returns
- $48mm paid back to investors first (invested capital plus fees paid in)
- $72mm remaining to split
- So, in this case the management would take $14.4mm and the investors would get $57.6mm. It may sound like this was a great outcome, but depending on when the investments were made, the return actually isn’t that high - probably between 10% and 20% per year.

Now, to the implications for all of this:

• It turns out that, given the number of deals a VC looks at, they generally target between 10 - 20 deals per fund. Another way to think about this is that the average investment in any given deal is 5% - 10%. If you are talking with a $200mm fund, they are probably most comfortable (and happiest) if they believe they will have an opportunity to invest at least $10mm and as much as $20mm in the deal.They may be willing to do a $5mm deal, but it will probably be one of the smaller deals in their portfolio (with implied prioritization).
• Given that VCs don’t have a lot of time to manage companies within the portfolio, they have to think in terms of managing the portfolio. As such, they’ll probably expect the normal rule of thumb that 3 deals will be hits, 3 will fail and the rest will essentially break-even. The implication here is that they have to believe that any one of their deals has a realistic chance of delivering 10X or more type returns (so that it can pay for other losses). Their incentive to “swing for the fences” also relates to the fact that they don’t receive any upside compensation from the fund until they hurdle the preferred return. So, VCs are typically not the best investors for deals that are a “safe double” - they are more interested in a portfolio of relatively higher risks deals that have the potential to be home runs.
• The combination of the above two factors can help entrepreneurs understand valuations. If a VC is investing $5mm they need to believe that there is a very good chance that they’ll achieve $50mm upon an exit. So, if the post-money valuation on the company is $15mm, this means that the company will need to be worth at least $150mm. VCs will tend to set valuations for companies by backing into them from a “realistic exit”. In this scenario, if they think the company can only achieve a $100mm exit, which means the post-money will need to be $10mm (pre-money $5mm).
• Entrepreneurs need to think a lot about the dynamics of the fund they are meeting: where are they in terms of the funds they have available to invest; what is their “ideal” size of investment; what is their “ideal” size of exit in order to justify their time?

This is a short summary of a much longer discussion. Please drop me a note if you have any questions!

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