Venture Capital Funds: Definition and How It Works

What are Venture Capital Funds?

Venture capital funds are investment funds that manage the money of investors seeking equity stakes in startups and small- to medium-sized enterprises with strong growth potential. These investments are very high-risk/high-return opportunities.

In the past, venture capital (VC) investments were only accessible to professional venture capitalists, but now accredited investors have a greater ability to take part. Still, VC funds remain largely out of reach to ordinary investors.

Key Takeaways

• Venture capital funds manage investments in high-growth opportunities in startups and early-stage firms.
• Hedge funds target high-growth firms that are also quite risky, so they are only available to sophisticated investors that can handle losses, illiquidity, and long investment horizons.
• Venture capital funds provide seed money or "venture capital" to new firms seeking accelerated growth, often in high-tech or emerging industries.
• Investors in a VC fund earn a return when a portfolio company exits, either through an IPO, merger, or acquisition.

Understanding Venture Capital Funds

Venture capital (VC) is equity financing that gives small companies the ability to raise funding before they have begun operations or started earning revenues or profits. Venture capital funds are private equity investment vehicles that invest in firms with high-risk/high-return profiles based on size, assets, and stage of product development.

Venture capital funds differ from mutual funds and hedge funds in that they focus on a specific type of early-stage investment. All firms that receive venture capital investments have high-growth potential, are risky, and have a long investment horizon. Venture capital funds take an active role in their investments by providing guidance and often holding a board seat. VC funds play an active role in the management and operations of the companies in their portfolio.

Venture capital funds have portfolio returns that resemble a barbell approach to investing. Many of these funds make small bets on a wide variety of startups, believing that at least one will achieve high growth and reward the fund with a comparatively large payout. This mitigates the risk of some investments folding.

Operating a Venture Capital Fund

Venture capital investments are seed capital, early-stage capital, or expansion-stage financing, depending on the maturity of the business at the time of investment. However, regardless of the investment stage, all venture capital funds operate and are regulated in the same way.

Like all pooled investment funds, venture capital funds must raise money from outside investors before making any investments. A prospectus is given to potential investors who then commit money to the fund. All investors who make a commitment are called by the fund’s operators, and investment amounts are finalized.

From there, the venture capital fund seeks private equity investments that have the potential to generate large returns for investors. This normally involves reviewing hundreds of business plans in search of high-growth companies. The fund makes investment decisions based on the prospectus’ mandates and the expectations of the investors. After an investment is made, the fund charges an annual management fee, usually around 2% of assets under management (AUM), but some funds may not charge a fee except as a percentage of returns earned. The management fees help pay for the salaries and expenses of the general partner. Sometimes, fees for large funds may only be charged on invested capital or decline after a certain number of years.

Venture Capital Fund Returns

Investors of a venture capital fund make returns when a portfolio company exits, either in an IPO or a merger and acquisition. Two and twenty (or "2 and 20") is a common fee arrangement in venture capital and private equity. The "two" means 2% of AUM, and "twenty" refers to the standard performance fee of 20% of profits made by the fund above a certain predefined benchmark. If a profit is made off the exit, the fund also keeps a percentage of the profits—typically around 20%—in addition to the annual management fee.

Though the expected return varies based on industry and risk profile, venture capital funds typically aim for a gross internal rate of return around 30%.

Venture Capital Firms and Funds

Venture capitalists and venture capital firms fund various types of businesses, from dotcom companies to biotech and peer-to-peer finance companies. They open up a fund, take in money from high-net-worth individuals, companies seeking alternative investments exposure, and other venture funds, then invest that money into smaller startups known as the VC fund’s portfolio companies.

Venture capital funds are raising more money than ever before. According to financial data and software company PitchBook, the venture capital industry invested a record $136.5 billion in American startups by the end of 2019. The total number of venture capital deals for the year totaled nearly 11,000, an all-time high. Two recent deals included a $1.3 billion investment round into Epic Games, as well as Instacart’s $871.0 million Series F. Pitchbook also cited an increase in the size of funds, with the median fund size rounding out to about $82 million, while 11 funds closed out the year with $1 billion in commitments including those from Tiger Global, Bessemer Partners, and GGV.