Understanding What VC Funds Are and How They Make Money

In 2021, VC funds invested $643 billion in startups, even though, by statistics, 90% of young companies fail. Knowing this, how do funds decide to invest hundreds of thousands of dollars in them? 

The beginning of venture capital

The emergence of the first VC firm is associated with the name of investment banker Arthur Rock. In the 1950s, he put $1.4 million into a group of inventors (Traitorous Eight) who created a new type of transistor. These inventors later created companies like Intel, Xicor, and Intersil.

Rock moved to California in 1961, where he started the first venture capital fund called Davis and Rock.

VC funds vs banks

Let’s say Peter has an idea of an online telemedicine service that would allow people to get a consultation from a doctor anywhere in the world. He is sure his startup has high growth potential, but he needs $150k to start it: hire key employees and develop a mobile app.

He does not have enough savings and his friends and parents cannot help. Peter goes to the bank and gets a refusal there — his idea is very risky, and he has no property as collateral.

This is where VC funds come into play.

The investors are interested in Peter’s idea, knowing that the telemedicine market is fast-growing and is expected to reach $16.7 billion by 2025. 

In exchange for the money, Peter gives investors a stake in his company. And if his idea fails, he won’t be in debt.

Where does a VC fund get its money from?

I like the joke that VC funds are like Robin Hood — they take money from the rich and give it to those who need it. But who are these “rich people” in this metaphor, whose money the fund manages?

These are insurance firms, pension funds, and individuals wanting to invest their own capital. They invest their money in a VC fund, receiving a stake in it.

The money is managed by fund managers — specialists who know how to make money work. In most cases, investors cannot directly influence the fund’s financing decisions, but the critical investment criteria (industry, stage, business model, location, etc.) are discussed in advance. This discussion results in a document called an investment thesis.

Individuals who invest their money in startups directly are called angel investors.

How does a VC firm make money?

When a VC fund invests in an early-stage startup, on average, it gets a 10-20% stake in it. Over time, as the company grows and its value increases, the fund can sell its stakes at a much higher price (say, 10x) and exit. 

There are four ways to have an exit:

1. IPO. The company’s shares are sold on the stock exchange and purchased by the general public.

2. A large corporation buys a startup, and a fund sells its shares.

3. Other VCs buy shares in a startup owned by a VC firm.

4. Bankruptcy (not the most favorable, but also an exit).

When a VC fund gets money from the sale of its stake, it does not take it all for itself but pays off the fund’s investors first. 

An example: 5 investors have invested $200k each in a venture capital fund. After the first exit, the fund makes $500k and gives all this money to investors —  $100k each. The fund then waits for the next exit to return the rest of all the money the investors put in it.

In most cases, a VC fund starts distributing bonuses — and making money for itself — only after it has returned the initial sum invested in it.

With the consequent exits, anything earned above the initial invested sum in the VC fund is shared in the following way: 80% goes to the investors and 20% — to the fund.

Why do VCs invest in startups at different stages?

Each stage has a different risk and return profile. In the early stages, VCs face higher risks and lower valuations, meaning they can potentially invest less and earn more. Most startups fail, but those that survive make up for the losses of those that failed.

To increase their chances, VCs invest in industries that they know well to help startups survive and grow. The startup uses the VC fund’s expertise to reach the next stage and raise new rounds.

Also published here. 

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