How Venture Capital Investors Make Money

How venture capital investors make money?

Understanding how VCs operate and make their money is important for startup entrepreneurs. When it comes to fundraising and pitching investors, this is like understanding your customers. A good grasp on how they function will enable you to better position your company to attract capital, and position your venture to secure investments from the best VCs, on the best possible terms.

So how do venture capitalists work? How do they make their money? How does this impact the investment decisions they make? How might these factors differ from other sources of financing for startups?

What Are Venture Capital Investors?

VCs are investment firms that manage capital and investments for other investors.

While what we see as traditional venture capital firms today are perhaps most commonly affiliated with Silicon Valley, we have seen them branch out internationally, with a presence overseas, and similar local entities around the globe. NYC, London, Israel, and other popular tech hubs have seen this ecosystem develop dramatically over recent years.

Venture Capital companies themselves raise money in the form of different funds. These funds often have a timeline of seven to ten years. During this, they invest and hope they generate good returns. While managing their investments.

These firms invest the capital they are entrusted with in alternative investments. In this case, startup companies. Which they hope will grow dramatically over the course of the fund’s life cycle.

Keep in mind that in fundraising, storytelling is everything. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.

Popular VC Firms

Well-known venture capital firms include:

• Sequoia Capital
• Kleiner Perkins
• Bessemer
• Andressen Horowitz
• Insight Partners
• Tiger Global Management
• Lightspeed Venture Partners
• Google Ventures
• Khosla Ventures
• General Catalyst
• Founders Fund
• Accel
• Benchmark Capital

How Venture Capital Investors Make Money?

LPs & GPs

Limited Partners are those who invest their money into venture capital funds. General Partners are those who invest and manage that money on behalf of their LPs.

In venture capital, LPs are often also large institutions or investors. Including pension funds, sovereign funds, family offices, etc.

LPs have limited liability. They are only exposed to financial losses if GPs choose investments poorly, or do not manage them well.

Fees & Splits

Typically LPs are paid out 70% to 80% of the gains made from VC investments. The company retains the other 20% to 30%. GPs also usually collect annual management fees, which may run from 2% to 3% of the capital in a given fund.

Investors in VC funds are hoping for strong double-digit returns. Growth investments that offset other lower risk, lower yield investments.

VC firms must deliver strong performance to retain those funds and to entice LPs into investing in future funds. Especially as this landscape has given birth to many more competitors vying for the same capital.

Lots Of Bets, Few Big Wins

Startup failure rates are extremely high. At least 9 out of 10 new business attempts fail in the first few years. Most do not even make it 12 months.

This means that the majority of companies that venture capital investors put their money into will go bust. Even though they may be very selective in the companies they provide funding to.

Imagine if they split a fund into 10 equal investments, one must return at least 10x to help the fund break even at maturity.

In order to deliver 100% return over the life of the fund, they must find some huge winners, without outsized success.

What VCs Do All Day

With the above in mind, you’d think that VCs would spend the vast bulk of their time selecting new investments. That’s not the case, according to HBR, which says they spend just 5% of their time on this task.

In fact, they reportedly spend the most time (25%) serving as directors and monitors of the companies that they invest in. As well as spending another 15% of their time acting as consultants.

With this in mind, it appears that managing and nurturing the investments they make is even more important than the ventures they choose to financially back.

How VCs Evaluate Startups

How do venture capital investors pick their investments? That’s the first thing to understand before you figure out how venture capital investors make money.

Popular VCs can easily attract 1,000-plus pitches each week. They are bombarded by funding requests from all types of entrepreneurs and companies all over the world.

In fact, a whole new industry has formed just to support this. Including fundraising consultants, pitch deck design agencies, startup lawyers, and more.

In addition to receiving inbound pitch decks, and attending events where founders are pitching their ventures, VCs are also certainly on the lookout for fast-growing companies on the rise. However, the human element is still a major influencer here. Introductions, and who you know are as important as the fundamentals and data on a startup.

What is most important in investment will vary by the stage of the startup an investor is putting their money into.

With early-stage startups, investors may have very little to go on besides the resume and grit of the founders, and the fundamentals of the market they are engaging in.

Traction, and proving that hyper growth is possible, with acceptable unit economics, is also clearly vital in order for VCs to achieve the returns they promise their LPs.

So, having the best team in the space, great traction, and a very large market, with a profitable business model are all boxes your startup needs to check off.

In Later-Stage Startups

In later-stage startups, the data and numbers become much more important. Including revenues and profit margins.

The location has certainly been a factor in the past too. While it may be less of an issue now, it has traditionally been easier to raise from VCs you are close in proximity to, than those in other regions or continents.

Of course, VCs are human too. Data and AI aren’t perfect yet, either. Meaning that they can make mistakes by drawing the wrong conclusions from data and patterns, and just by falling into trends. Just as Sequoia lost everything on its bet in FTX and Softbank lost hugely on WeWork.

VC Payouts

The biggest paydays for VC investors are from exits. They may make and take money from profits and dividends as shareholders in companies they invest in. In some cases, they may be cashed out by investors who follow them.

Most commonly, the big paydays come through IPOs, mergers, and acquisitions. They need those big windfalls.

That means once you accept venture capital money into your startup, you are setting your company on a course for an exit. Much of the direction and decisions made in the following months and years are going to be targeted toward driving up valuation, bringing in new rounds of capital, and securing an exit. Often through being acquired. That’s one of the strategies for how venture capital investors make money.

Pick Your Investors Wisely

With the above in mind, it is extremely important for startups to select their investors wisely.

There may certainly be times when it seems that you need to take any money available, at any cost, on any terms.

This can certainly cost you later. Not only in interest or finance charges but in the mission and what you wanted to do for the world, as well as your slice of the pie when the company is sold.

In addition to giving up equity in your company, you will normally be giving up board seats and some decision-making control.

Evaluate potential investors carefully on their track records, and by talking to others about their experience with them. How have they treated other founders? Do they share your values, beliefs, and vision? Do they support their startups during tough times? Or are they fast to take over?

While reading about how VCs make money, you’ll also want to know more about how venture capital works. Check out this video, where I explain in detail how it’s done.

How Other Startup Funding Works

Of course, VC firms are just one type of investor in the startup ecosystem. There are other options to include in your financial stack. How are they different?

Angel Groups

Instead of being mostly backed by big institutions, angel groups are more commonly made up of individual angel investors who band together to make investments in startups.

They may invest at earlier stages, with smaller amounts of capital. They make money in similar ways. They help their members diversify more broadly, lower risk, and increase upside potential. While wielding more power to make their investments a success.

Individual angel investors are high-net-worth individuals who invest their own capital into startups. Normally smaller amounts in the earliest stages of a new venture.

Startup Accelerators

Startup accelerators can provide seed capital. As well as mentorship and structure for focusing and making swift progress over a few months. After which, the program culminates in a demo day, where founders pitch their companies to a new round of investors.

Great accelerators can help force progress, make introductions, and give startups more credibility.

Convertible Notes

Convertible notes are a hybrid form of investment between equity capital and debt financing. They are normally used in the early stages of a startup when the odds of success and size of success are unclear.

This type of funding begins as a loan. Which can then be converted into equity at a later point, should the investor-lender wish.

Loans For Startups

There is a wide variety of credit options available to businesses.

This can include business credit cards, business lines of credit, and more. There are secured and unsecured options. Including asset-based lending. For example, for real estate or equipment financing.

There are SBA loans for various situations that are made available through approved intermediary lenders.

The upside of debt financing for startups is that it does not require them to give up shares and control in their business. The downside is the impact on their balance sheet, repayments, and interest, which can put a strain on young companies.

Factoring loans, like merchant cash advances, enable companies to take advances on future income. Then repay creditors as their income comes in.

Grants

Grants can be an attractive form of non-dilutive capital for startups. There are various types of grants. They can be available at the state, federal, and local levels. Normally, this money does not have to be repaid. It is effectively free capital, provided you use it properly.

Receiving grants and other award money can also be great for your startup’s resume and pitch deck.

Summary

Understanding how venture capital investors and other sources of funds that provide cash to startups is vital for founders.

This helps you get where investors are coming from, their needs and responsibilities, and how they view pitches and pitch decks.

In turn, it gives some insight into how you can expect investors to act after you’ve brought them into your company.

Informed startup entrepreneurs will understand the pros and cons of various types of funding that they can add to their capital stack, and where it best fits in. As well as what to look for in the best funding sources. Take the time to understand how venture capital investors make money.

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