#17 - The Structure of VC Firms
How to navigate the hierarchy of venture capital firms. Who makes the final investment decision?
Who’s confused by the titles of most venture capitalists? The structure of the venture capital firms could be daunting even for seasoned entrepreneurs, as there is no golden standard to how all the firms operate. There are, however, accepted standard practices that can help us understand the general hierarchy of a venture capital firm.
By the way, if you are completely new to the VC world, check out first the article on the basics of venture capital and make sure to subscribe!
Components of a VC Firm
There are three crucial parts to every VC firm in the world: the fund, limited partners, and the fund’s management team.
The Fund
A VC fund is a managed pool of money from the investors (limited partners, or LPs). That pool of money is used to invest in various startups and it is common that a fund will specialize in specific industries. It has also become normal for a venture capital firm to have multiple funds open at the same time which specialize in different stages of investment (some funds could focus on more risky early stage while other funds focus on more stable late stage investments).
Limited Partners (LPs)
Limited partners are the "external" investors to the fund (they provide the money used by the VC firm for their investments). A limited partner does not have to be a person — in fact, business entities compose the majority of funding for venture capital firms. Some common LPs include insurance companies, endowments, foundations, and pension funds. LPs give money to the fund with the hope of getting greater returns than the stock market or other investment approaches.
General Partners (GPs) and Other Management
Finally, general partners are the top management of a venture firm — they manage the funds and often make the final call regarding which companies to allocate funding. GPs are compensated with a management fee, often roughly 2% of the fund, along with carried interest on their investments. The carried interest usually depends on the success of the fund, with greater returns for the fund leading to a larger allocation of carried interest. Larger funds also contain a team of associates, analysts and platform managers to help vet investments and foster a strong community for the fund’s portfolio companies.
The Funding Cycle
The funds tend to "live" 7-10 years on average, as that is the approximate period from the initial investment to a company to the return on investment. There are 3 main stages to a fund's lifecycle:
Initial Investment, "Planting the seeds": This stage typically lasts for 2-3 years, and the goal of the firm during these years is to discover (and then invest) in as many great opportunities as possible. By diversifying their investments, VCs are able to slightly decrease the risk that come with investing in startups. During this stage, VC firms tend to use only about 50% of their fund leaving the rest for follow-on investments.
Follow-On Investments, "The harvest stage": This stage usually lasts 2-4 years and focuses on providing additional investment to companies already in the VC firm’s portfolio to help them grow. Smaller VC firms may often skip this part entirely as they won't have enough funds to further invest.
Fund Closure and Returns, "Reaping the profits": Finally VC firms and LPs get a return on their investment which often comes from a company being acquired or going public. A VC firm will typically close their fund once all their portfolio companies have exited or gone out of business. If you want to learn more about exits, stay tuned for one of our upcoming articles!
Diving deep
If you want to get a deeper understanding of how venture firms work inside, check out these articles: