Understanding Venture Capital Funds

Starting up your very own business may get a lot of pondering, guts and money. Most of us would rather be their own boss than turn out to be a person else’s employee. Luckily new entrepreneurs have other alternatives in discovering funds for their company. Venture capital is a type of private equity capital typically provided by outside investors to new businesses. Generally made as cash in exchange for shares in the investee company, venture capital investments are usually high risk, but offer the potential for above-average returns. A venture capitalist is a person who makes such investments. A venture capital fund is a pooled investment scheme that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. Venture capital can also include managerial and technical expertise.

Venture capital firms acquire capital from accredited and sophisticated investors with the intent to make investments into private held businesses. On very rare occasions venture capital funds will make investments into publicly traded businesses. As stated above, VC firms only can raise capital from individuals and organizations known as accredited investors. In the case of individuals, a person must have a net worth of at least $1 million or have earned an income of $200,000 per year in each of the last two years. Organizations, such as trusts, banks, and companies typically must have assets exceeding $5 million. Once the venture capital firm has raised capital from these accredited investors, the funds are pooled into one fund. Very large venture capital firms often have a number of funds that overlap and make similar investments.

The fees that venture capital firms can receive are enormous. Typically, a venture capital management firm receives 20% of the profits from each successful transaction plus a fee equal to 1% to 2% of the total assets managed by the business. If the specific venture capital fund is not profitable for any given year, they do not receive their incentive fee. It is not unusual for highly seasoned venture capital management firms to generate billions of dollars in profits from making continually successful investments.

Once profitable investments are sold or taken public, the profits from the sale are distributed to investors. As stated earlier, the incentive fees for profitable transactions typically are 20% of the aggregate profits generated by the venture capital fund. The remaining 80% are distributed to accredited investors. The entrepreneurs that founded the business in which the venture capital firm made an investment are also compensated handsomely. Typically, the senior management team keeps 15% to 30% of the business that they have developed. They may also be provided with lucrative compensation packages that include bonuses, stock options, and restricted stock.