Understanding Venture Capital Fund Structures

 Introduction

Venture Capital (VC) funds are one of the most significant sources of funding for early-stage companies that have the nature of a corporation by having a name ‘startups’ and whose growth potential is high. Therefore, it is very crucial that for entrepreneurs applying for venture capital funding, as well as for an investor who would want to buy VC as a class, there is an understanding on the structure of VC funds. The structures of a VC fund describe how funds are raised, managed, invested, and distributed: they involve returns to investors and support to portfolio companies.

1. The fund and the basic structure of a venture capital fund:

• The classical structure for venture capital funds has been that of a limited partnership. Venture capital funds consist of two general categories: the General Partners (GPs) and the Limited Partners (LPs).

• General partners (GPs): GPs manage the administration of the fund, take all investment decisions, and provide hand-on support to portfolio companies. The GPs also screen potential investments, conduct due diligence on an appropriate set of investments, and, finally, generate returns for the fund.

• LPs are those investors who invest capital in the fund. The LP list would include institutional investors, high-net-worth individuals, family offices, and sometimes corporations. LPs’ risk is limited because they can lose only up to their investment in the fund, without any of them handling the management of the fund.

This is because, in this case, the GPs act as active managers of the fund, and LPs are passive investors.

2.  Venture Capital Funds How Raise Capital

• VC funds raise capital through a commitment by LPs. Such commitments are usually made for two to three years, and the fund “calls” some or all of it depending on investment opportunities that arise. Typically, the life cycle of a VC fund is roughly 10 years; extension, however, can be made if needed.

• Investment Period The life period of a VC fund is articulated in the following as an investment period within 3-5 years where most of the investment is made from GPs. The capital put by LPs during this period gets money through opportunities exploited by GPs.

• Harvest Period The time frame begins immediately after the investment period during which the fund enters into years 6-10, also known as the harvest period. During this stage is when the emphasis of the fund shifts from making new investments to managing and exiting the existing investments.

3. Capital Deployment and Investment Cycles

The VC funds invest their capitals in various rounds of investment in a startup. Most start-ups fall under the stages outlined below:

• Seed Stage: It is the earliest stage where small amounts of capital are invested in the starting phase of a startup to fund the building of the product and do some market validation.

• Series A: Same round of funding achieved by start-ups that are showing early stages of success and maturity as they look to scale.

• Series B, C and Beyond: Follow-on rounds to further scale the business, build out infrastructure, or expand into new markets.

Typically VC funds would have a pool of ready money for follow-on investments; hence continued investing in its portfolio companies through multiple rounds as the startup matured and grew.

4.  Portfolio Diversification and Risk Management

By its very nature, venture capital is a risky investment, and so VC funds diversify their investments broadly across a portfolio of companies. Most VC funds will invest in 10-30 companies and expect that:

A small percent of the portfolio (around 10% of the portfolio) are going to yield high returns often called “home runs”.Some will break even and some will turn into losses.

VC funds assure diversification in investments over a number of companies; hence the risk of loss of total capital is reduced. Instead, the chances for earnings in large amounts from high-growth companies are increased.

5. Exit Strategies and Returns

Venture capital funds make returns for the investors through the various kinds of exits. They occur most often in such a sequence:

IPOs: When such firms are listed on the stock exchange, the shareholders have their shares issued.

Takeover of a portfolio firm by a well-established larger company. These help the VC fund realize and cash in on profits going back to LPs and GPs through carried interest. In other words, some may be paid as dividends or distributions from a profitable portfolio firm.

6. Fund Lifecycle and Wind-Down

The lifecycle of a VC fund is usually 10 years, but can be up to 15 years. In those years, it will go through different phases:

• Fundraising: Year 0-1; GPs raise commitments from LPs

• Investment Period: Year 1-5; It is when the fund invests in start-ups and invests most of its money in the period.

• Harvest Period: Year 6-10; This is the harvesting investment phase, winding down the investments, and returning the money to the LPs.

• Wind-Down (Year 10+): This is an extension of the fund as the remaining outstanding investment or unresolved issue is resolved

Once all investments have been harvested with the return of capital, close the fund.

Conclusion

The other structure involved in the understanding of venture capital funds is very crucial for startups raising their investment and venture capital as an asset class. Diversion of portfolios, careful capital management, and concentration on scalable businesses maximize VC fund returns for both GPs and LPs over a long period of time. The good thing about this standard limited partnership structure is that there is a balance through fee arrangement and investment strategy to balance risk and reward while making provision for long-term growth in high-potential companies.

FBS