The Structure Behind VC Firms

It’s understood that startups raise money from VCs for the purpose of growing and scaling the company, possibly towards an exit down the road. It’s also no secret that VCs provide the capital to founders to help them grow and scale the company in hopes of that exit occurring at a faster and more lucrative rate. What is less known is how the VCs provide this capital and where they get the resources to help startups achieve financial success. It’s all embedded in how a VC fund operates.

To start with, let’s say you are a VC want to set up shop with your own fund. To do that, you need to have money. To have money, you go on a fundraising trip, much like a founder does. You meet with various groups of people who represent organizations such as pension funds, insurance companies, endowment funds, high net-worth individuals, or fund of funds. These groups and organizations become the Limited Partners (LP) that give their money to you, a General Partner (GP). Once enough money is raised, that’s when the fun begins.

The first thing you do before you even start raising money is to establish your firm. Your firm is the overarching entity that comprises the fund and is also known as the Management Company. Usually these are established in the same state where the partner physically operate. Once you have the firm incorporated, that is when you create your fund. If you’re really good at what you do, you will likely establish multiple funds over time, but for now let’s focus on the first one. The fund is where the LPs are investing their money. One thing to note is that most LPs will want you to invest some of your own money as well into the fund, usually with a GP-LP ratio of around 1 : 99. So if you raise a $100 million fund, you will be making up $1 million of that. This is done in a legal entity that is set up separately from the Limited Partnership entity to avoid being charged management feeds or interest from carry, which we’ll get to.

For corporate law and tax purposes, these funds are best served by being incorporated in Delaware (startups seeking funding will also be asked by VCs to be incorporated there as well). This fund, which now has capital from two separate entities (one from the LPs, the other from the GPs), is where VCs invest capital into startups. This fund is also responsible for the “2 and 20” deal that is standard among compensation models. The 2 refers to the percentage of the fund given to the firm as a management fee. This fee covers areas that are critical to operating a firm, such as travel expenses, office rent, and salaries. The 20 comes in the form of carry. If a fund has a very successful return, they usually get 20% of anything left over after LPs get their investment back. That 20% is then split among the GPs, and if they’re nice enough, to some of the junior Partners or Principals.

As mentioned before, if you happen to succeed in the first fund, you usually will want to set up the second one. Because most funds are set up with a life expectancy of 10 years with a possible extension of up to 2 years, it is expected that you will be enjoying the fruits of your labor in a set time period. New funds under a firm are set up every 3-5 years in order to keep pace with the commitment period, which is the time where you take the money you raised from LPs and yourself and invest in companies. This is usually done within the first 5 years of the fund’s life, while the rest of its existence is based on providing additional capital (also called reserves) to portfolio companies that were invested in during the commitment period.

Just like how founders are expected to provide an update to their board of directors, GPs are expected to provide updates to their LPs. To a founder, they may think the VC has total control, but that’s not true. VCs report to their LPs to update them on how things are coming along. The use of metrics is relied on heavily and the Internal Rate of Return, along with the multiple, are the most critical metrics in a fund.

If you are a founder, knowing the structure of how VC funds operate helps in the long run because you can understand where the VCs are coming from. Every move they make and every step they take is done for two reasons: to help your company grow and scale and eventually exit, and to ensure they are doing everything possible to create plenty of returns for their LPs.