How does venture capital work?

Venture Capital Firms and Funds

You often hear about Venture Capitalists (VCs) funding Dot Com companies, and they fund all sorts of other businesses as well. The classic approach is for a venture capital firm to open a fund. A fund is a pool of money that the VC firm will invest. The firm gathers money from wealthy individuals and from companies, pension funds, etc. that have money they wish to invest. The firm will raise a fixed amount of money in the fund -- for example, $100 million.

The VC firm will then invest the $100 million fund in some number of companies -- for example, 10 to 20 companies. Each firm and fund has an investment profile. For example, a fund might invest in biotech startups. Or the fund might invest in Dot Coms seeking their second round of financing. Or the fund might try a mix of companies that are all preparing to do an IPO (Initial Public Offering) in the next 6 months. The profile that the fund chooses has certain risks and rewards that the investors know about when they invest the money.

Typically the Venture Capital firm will invest the entire fund and then anticipate that all of the investments it made will liquidate in 3 to 7 years. That is, the VC firm expects each of the companies it invested in to either "go public" (meaning that the company sells shares on a stock exchange) or to be bought (acquired) by another company. In either case, the cash that flows in from the sale of stock to the public or to an acquirer lets the VC firm cash out and place the proceeds back into the fund. When the whole process is done, the goal is to have made more money than the $100 million originally invested. The fund is then distributed back to the investors based on the amount each one originally contributed.

Let's say that a VC fund invests $100 million in 10 companies ($10 million each). Some of those companies will fail. Some will not really go anywhere. But some will actually go public. When a company goes public, it is often worth hundreds of millions of dollars. So the VC fund makes a very good return. For one $10 m­illion investment, the fund might receive back $50 million over a 5 year period. So the VC fund is playing the law of averages, hoping that the big wins (the companies that make it and go public) overshadow the failures and provide a great return on the $100 million originally collected by the fund. The skill of the firm in picking its investments and timing those investments is a big factor in the fund's return. Investors are typically looking for something like a 20% per year return on investment for the fund.