Getting to know the VC world: Part I

This is Part I of a variety of different entries that I, Ashkan Afkhami, will be writing about in regards to terms, processes, and insight you should know as an Entrepreneur based on my experience working at the Venture Capital firm, Hercules Technology Growth Capital.

This week, I will give a general overview of how Venture Capital firms function:

The traditional Venture Capital firm typically invests in early stage companies. The majority of the money that they invest with is from Limited Partners.

The following depicts the relationship between the vested parties:

Limited Partners (LP’s) are the individuals, institutions, foundations, etc… that provide the capital for the firm.

General Partners are the Venture Capitalist making the investments and running the funds. The General Partners typically put in a small amount of money, while the LP’s account for the majority of the fund.

Venture Capital Funds: these are the funds where money is pooled together to be invested. These investments can be made from the beginning of the fund, or is in the form of a commitment as needed basis for the life of the specific fund (approximately 10 years). These are typically set up as Private Partnerships.

The process:

1. Venture Capitalists raise money from Limited Partners

These include corporations, private pension plans, endowments/foundations, state pension plans, and wealthy families. (See picture above)

2. VC’s invest that money into companies [Portfolio Companies]

Hundreds of companies and business plans are scrutinized and only a select few make the cut; approximately 3% to 8% of all plans are selected for investment, depending on the fund, type of investment, and overall economic climate

3. In return, the VC firm receives an equity stake in each company [% of the company]

In exchange for a financial investment, the company pays the venture firm in percentage of ownership (equity) of the company.

4. The VC firm looks for a Return on Investment [Typically 5 to 10 years after investing] 

Through a merger/acquisition, buyout, or Initial Public Offering (known as an ‘exit’), the VC firm is able to extract value from their investment through either cashing out or maintaining stock ownership in the portfolio company.

5. The General Partners / VC firm receive compensation

A certain percentage of the return from each portfolio company investment will be held by the firm and the general partners are rewarded based on the performance of the companies they selected to invest in. The remaining proceeds are then distributed to the rest of the Limited Partners based on a predetermined percentage.

Upon distributing the last of the fund's proceeds, the process can be repeated, starting with the raising of a new fund.

If you have any questions about VCs and investment, please post a comment. I will try to work it into a future post so that everyone can benefit.