How do Venture Capital (VC) companies actually work?
7th Feb 2019
4 min read
Have you ever heard the expressions VC’s, LPs, Term Sheet, Fund returner, Multiples, or hurdle rate and asked yourself: What the heck do they actually mean? They are all commonly used phrases and abbreviations in the fields of Venture Capital and Entrepreneurship. This article presents the structure behind a typical VC company with the help of common examples. The writing style is kept on an easy-to-understand level on purpose to be considered as beginner’s guide.
4 Important terms one must comprehend to understand a VC system
Limited Partners (Investors)
Limited Partners (LPs) are external investors such as large corporate companies, family offices, or wealthy individuals who want to invest their money with the willingness to take on a higher risk than normal retail investors. On average, LPs expect a return of 15-20% p.a. over the fund duration of 7-10 years.
The Fund is the final bucket where all the money is collected. The process of searching for investors and negotiating about the terms of investments in the fund are called fundraising. Investments that are conducted are taken from the fund. The size of the fund is a good indicator for the size and experience of the VC (the longer the VC is in the market, the higher the trust – if they performed well – and the more likely investors are to re-invest even larger sums). A normal fund has a lifetime of about ten years, with an investment period of five years and a cash-out /further investment phase of the missing five years.
The longer the VC is in the market, the higher the trust – if they performed well – and the more likely investors are to re-invest even larger sums
General partners are employees of the VC and are comparable with the CEO of traditional companies. Normally, they also are the founders of the fund or joined before the next fundraising process has started. The main responsibility of GPs is the investment decision (final decision maker). In order to give LPs a better feeling and to ensure general partners will invest foreign money only in high-potential targets, GPs are also financially involved in the fund by a certain percentage. Besides, the management is additionally incentivized by receiving a management fee of the fund (comparable to a salary) and receive a provision (around 10%) at the end of the fund duration if they surpass the hurdle rate (minimum rate of return on a project required by investors, typically around 15-20% after five to seven years).
Finally, after an average time of three to four months and the agreement on final terms, the actual venture starts, and the investment is conducted. In a typical startup portfolio of a VC there are specific numbers about how much money (multiples1) each investment returns.
For an easy explanation, let us assume that there have been ten investments in total. History has shown that around 30% of the VC backed companies fail. So, the return from the VC´s perspective will be 0€. Three other portfolio companies have a multiple of two to three x followed by three other investments that return four to five x. Consolidating all the returns, the total return would hardly cover the money invested plus a 15-20% additional return for the LPs. VC’s expect the tenth investment to return ten x or more. This one investment alone is expected to return the whole fund, that’s why it is called the fund returner.
Let’s have an easy example (Caution, some easy math included):
After fundraising, the fund reached an amount of ten Mio. €. General partners seek good investment opportunities and invest into ten startups, one million € each. Unfortunately, three investments go bankrupt after a few ears, three startups have the expected return of two x and four x respectively. Then the VC showed some good feelings about the development of the tenth startup which becomes the fund returner with a return of ten Mio. €. See the calculation in the following box:
The total ROI cumulates to 28 Mio. €. Deduct the fund size, a management fee of two percent, ten percent provision and the LPs end up with a net revenue of 16 Mio €, which is some 21% ROI per year. The VC performed quite good and surpassed the expectations of the investors (LPs).
Play with the numbers and see how the net revenue changes if there is no fund returner or half of the portfolio fails.
I hope this short insight into the VC system was helpful and all members of the HHL Venture Capital Club are happy to answer any questions – so feel free to ask in the comments below.
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