The Fine Print on Investing in Venture Capital

[Editor’s Note: In 2021, according to the PitchBook-NVCA Venture Monitor, investing in venture capital hit an all-time high with nearly $330 billion invested (about double from 2021) across about 17,000 deals. In addition, $774.1.4 billion in annual exit value was created by VC-backed companies going public or being acquired, and about $681 billion of that was realized through public listings, confirming the favorable conditions presented by strong public markets and valuations as well as the availability of SPACs as an alternative to IPOs. Overall, the venture ecosystem observed a sharp uptick in valuations across all stages of the investment cycle.]

So You Want to Be a Venture Capitalist? Join the Party

Investing in venture capital, while often defined in tandem with private equity, is really more like its unpredictable sibling. It’s in the same family, yes, but philosophically different in how one approaches the “buy low, sell high” challenge. Private equity (PE) involves the purchase of established companies; Venture capital (VC) invests in startups — and often in the people behind them. One might say that today’s VC-backed company may evolve to a PE-owned company someday.

Author Alejandro Cremades, in a Forbes article, puts it like this: “Think classical music, farms and assembly lines in contrast with the typical jazz, disruption, or street art style of fast growth startups. [Private equity investors] prefer predictability and lower risk.” For VC, it’s all about investing “at an earlier stage in the lifecycle of a startup.”

Time is Money: Investing in a Startup at Different Stages

Venture investments require long hold periods, typically at least 5 years.  Therefore, before you invest in one, you need to be prepared to tie your money up for a long time.  Since it takes time to select and execute investments on the front end and sell or “harvest” investments on the back-end, you should prepare to have any money you invest in a VC fund tied up for at least 10 years.

A VC fund is the most typical way to invest in a startup and, depending on the strategy of the fund, your money may go in at various stages of development.  This, in turn, will affect how long you wait to realize returns.

In its “Guide to Venture Capital,” investment banking services company, Madison Park Group, summarizes the stages of investing in venture capital:

1. Start-Up Stage

Newly formed companies without significant operating histories are considered to be in the startup stage. Most entrepreneurs fund this stage of a company’s development with their own funds as well as investments from angel investors.

Angels are wealthy individuals, friends, or family members that personally invest in a company. Angels are the most common source of first-round funding for technology businesses, and angel rounds usually fund less than $1 million, according to Forbes. They often will back companies that are at the concept stage and have a limited track record with respect to customers and revenue. These investors tend to invest only in local companies or people that they know personally.

2. Seed and Early Stage Funds

TheBusinessProfessor.com says seed or early stage rounds often involve investments of less than $5 million for companies whose promising concepts are validated by key customers, but they have not yet achieved a break-even cash flow point. That is, the lowest amount of income needed to ensure that production costs equal revenues. Organized groups of angel investors, as well as early-stage venture capital funds, usually provide these types of investments. Typically, seed and early venture capital funds will not invest in companies outside their geographic area (usually 100-150 miles from the VC’s office) as they often actively work with management on a variety of operational issues. One fifth of all Unicorns created in 2021 reached unicorn status after a Seed, Series A or B round. This is earlier than what is typical in a growth cycle. Markedly, this level of Unicorn creation is five times that of the prior year.

3. Growth Stage Funds

Growth stage funds focus on companies that have a proven business model. These companies are either already profitable or offer a clear path to sustainable profitability. These investments tend to be in the $5-20 million range and are intended to help the company significantly increase its market penetration.

The pool of potential venture capital investors is very robust for growth stage investments, with firms across the United States willing to participate in investment rounds at this stage. Growing trends in how quickly companies reach Unicorn status highlight the importance of investing in earlier stages. 

4. Late Stage Funds

Late-stage venture capital investments tend to be for relatively mature, profitable companies seeking to raise $10+ million for significant strategic initiatives (e.g. investment in sales and marketing, expansion overseas, major infrastructure build-outs, strategic acquisitions, etc.) that will create major advantages over their competition. These opportunities are usually funded by syndicates of well-established venture capital firms that manage large funds.

5. Buyouts and Recapitalizations

Buyouts and recapitalizations are becoming more prevalent for mature technology companies that are stable and profitable. In these transactions, existing shareholders sell some or all of their shares to a venture capital firm in return for cash. These venture capital firms may also provide additional capital to fuel growth in conjunction with an exit for some or all of the company’s existing shareholders.

However, whatever the stage of investing in venture capital, if a VC fund turns out to be profitable in the end, the investor is not the first person to see returns when they come in.

Fees You Will Pay when Investing in Venture Capital Funds

The returns a venture capital firm earns on its investments are generally referred to as its “gross returns.”  Net returns, however, are what count. Net returns generally refer to the returns actually made by a VC fund investor.

It’s crucial for a fund to return twice its investment. Before investors see returns, the VC fund takes a management fee, as well as carried interest or “carry fee” on any profits. Some funds take a 2% management fee and a 20% carry fee, but some larger funds may take a 1% management fee with a 30% carry.

The good news is, if the fund doesn’t become profitable no carried interest is paid, so incentives are pretty well aligned. That said, VC funds are paid management fees, regardless of performance, intended to cover overhead. These fees vary widely, but a good-sized fund can yield very good salaries to fund managers — and that’s just the management fees.

Your Due Diligence About a Fund

So, you are new to investing in venture capital; perhaps you have never made a VC investment and are considering it now for the first time. Your first fundamental option along the decision tree is whether to do it or not. To do this, you need to weigh risks and rewards.

Your next fundamental decision is whether you will make your own investment decisions or you will invest in a VC fund. If you decide to go it alone, you may want to join an angel group. But, before you do, you need to ask yourself first if you are cut out to be an angel. If this is the way you decide to go, you need to learn how to walk the walk of an angel investor.

If, on the other hand, you prefer to put your money in the hands of a professional to manage investing in venture capital for you, you need to select that professional intelligently. Before you invest in any fund, it is  important to understand the legal relationship that will exist between you and the fund once you invest. You, and/or your lawyer and/or accountant, must review the fund’s limited partnership agreement.

Is VC for You?

As in any other investment class, there are winners, losers, and those everywhere in between. As new funds and angel groups enter the space, whether it be in tech or health care, people need to be more vigilant than ever in doing their due diligence.

Further, if you are a first-time investor looking to invest in a startup, understand that you have a lot to learn about investing in venture capital. If you do not take time to gain that insight, you might do as well to visit the nearest convenience store and buy a stack of lottery tickets.

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

• PE, VC, and Hedge Funds De-Mystified
• What is a “Private Fund?”
• Due Diligence Before Investing

This is an updated version of an article originally published on September 30, 2013, and previously updated June 6, 2019. It has been updated by Nora Willi]

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