Venture Capitals raising money : How?

How Venture Capital Firms Raise Money

Venture Capital firms raise money by establishing venture capital funds. These funds are the pools of capital that VCs use to invest in startups.

Sources of Capital for VC Funds: Limited Partners (LPs) VCs raise money from various entities known as Limited Partners (LPs). These are typically large institutions that seek high returns on a portion of their capital, despite the high risk associated with venture capital. LPs include:

• Public Pension Funds: Funds managed for public sector employees.
• Private Pension Funds: Funds managed for private sector employees.
• University Endowments: Investment funds built from donations to universities (e.g., a university wants to maximize returns from its endowment to support its operations and growth).
• Sovereign Wealth Funds: State-owned investment funds.
• Corporations: Companies investing their excess capital.
• Family Offices: Private companies that manage investments and wealth for a single affluent family.

These LPs allocate a portion of their overall investment portfolio to high-risk, high-reward instruments like venture capital and private equity to diversify and maximize their overall returns.

The Role of General Partners (GPs) The fundraising process is primarily handled by the General Partners (GPs) of the VC fund. GPs are the handful of individuals who run the VC firm.

• They actively reach out to prospective LPs, presenting their expertise and investment strategy for the new fund they are assembling.
• Raising a VC fund is a significant undertaking, typically taking anywhere from 12 to 18 months.
• GPs also invest a small portion of their own money into the fund (e.g., 2-5%), which serves as a crucial signaling mechanism to LPs. This "skin in the game" assures LPs that GPs are committed to prudent investment and will work diligently for the fund's success.

Structure and Lifecycle of a VC Fund

A typical VC fund operates with a specific structure and lifecycle:

• Capital Contribution: LPs contribute the vast majority of the fund's capital, typically 95% to 98% (e.g., for a $100 million fund, $95-98 million comes from LPs). GPs contribute the remaining balance.
• Fund Life Cycle: A VC fund has a finite life, usually 7 to 10 years. This means that the GPs must deploy (invest) the fund's capital within this timeframe, ideally in the early part of the cycle, to allow sufficient time for their investments to mature and generate returns.
• Management Fees: A portion of the fund, typically around 2% annually, is allocated as a management fee. This fee covers the operational expenses of the VC firm, including GP salaries, office rent, travel, and other administrative costs. This means that if a fund is $100 million, over a seven-year cycle, approximately $14 million (2% per year for 7 years) would go towards management fees, leaving about $86 million for actual startup investments.
• Profit Distribution: At the end of the fund's lifecycle (or upon successful exit from investments), the returns are distributed.
  1. Principal Return: The LPs are prioritized and receive their initial invested capital (principal) back first.
  2. Profit Share (Carried Interest): Any profits generated beyond the returned principal are then shared between the LPs and GPs. The typical split is 80% to LPs and 20% to GPs. This 20% profit share, known as "carried interest," is a major financial incentive for GPs, motivating them to identify and invest in companies with the potential for extraordinary returns.
• Fund Closure: At the end of its limited life, the fund "closes its books." Shares in remaining portfolio companies are either transferred back to LPs or a notional value is attributed to them, effectively winding down that specific fund.

The limited timeline of a VC fund significantly influences the types of investments VCs make, favoring high-growth potential companies that can deliver substantial returns within the fund's finite life.