How to be an Angel Investor

What is a Venture Capital Fund?

Venture capital funds are pooled investment vehicles that provide capital to startups in exchange for equity.
December 9, 2021
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  • Venture capital funds invest in startups in exchange for an ownership stake in each company.
  • Venture investments are riskier than other asset classes but also carry the prospect for outsized returns.
  • VCs raise money from a network of limited partners, who can be wealthy individuals or institutional investors.
  • Venture capital funds make money when a portfolio company exits (e.g., via acquisition or IPO), typically within a 10-year timeframe.
  • Funds typically split profits between the fund manager (the general partner) and limited partners.

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Venture capital is a vital source of funding for high-growth startups across the globe and plays a disproportionately important role in spurring job creation and economic productivity.

Many of the world’s biggest companies (Alibaba, Alphabet, Apple, Amazon, Facebook, Microsoft, Tencent, and Tesla, etc.) started with funding and advice from venture capitalists (VCs). Venture-backed companies constitute nearly half of IPOs in the U.S.

Venture capitalists make risky investments in startups in the hopes of outsized returns—which is happening with greater frequency.

The industry has experienced substantial growth and innovation in the past decade. Today, more VCs than ever are investing more capital than ever.

A venture capital fund can now mean many things—from a traditional fund that invests in a  portfolio of companies over a 10-year horizon, to a single-deal SPV, to a Rolling Fund that accepts quarterly commitments.

In this article, we’ll break down the different components of running a venture capital fund, including how they’re structured, how they invest in portfolio companies, and how they generate and distribute returns to their investors.

What is a Venture Capital Fund?

Venture capital funds are pooled investment vehicles that invest in startups in exchange for ownership in those companies. Venture capital is a type of private equity, which means investments are not made available on a public market. 

Venture capital funds earn returns for investors in different ways. Most commonly, a fund will receive returns following a “liquidity event,” such as an initial public offering (IPO) or acquisition from another company. The proceeds will then be distributed among the fund’s investors on a pro rata basis.  

The manager of a venture capital fund is called a “general partner” (GP). A GP is responsible for raising money from a network of investors, selecting investments, and overseeing all of the operational, accounting, and legal aspects of the fund. A GP often follows an investment thesis to select investments, targeting a specific segment of the market and/or stage of investment.

Investors in a venture capital fund are called “limited partners” (LPs). They’re often high-net-worth individuals or other financial institutions seeking exposure to the venture asset class. 

Venture capital funds typically invest in a number of  startups, expecting some to fail, while hoping for a handful of big winners. The typical time horizon for most venture investments is 6-10 years.

How do Venture Capital Funds Help Startups?

Venture capital plays an important role in a company’s success. 

According to HBR, more than 80% of the money invested by venture capitalists goes into building infrastructure required to grow the business—in expense investments (manufacturing, marketing, and sales) and the balance sheet (providing fixed assets and working capital).

In addition to capital, many venture fund managers provide guidance to portfolio companies.

In fact, many VC firms build reputations for helping portfolio companies with recruitment, customer acquisition, access to follow-on funding, and advice on other challenges startups encounter.

How do Venture Capital Funds Make Money?

A venture capital fund invests in a company and then monitors the investment—potentially providing future financing in subsequent rounds—until the company experiences a “liquidity event” (e.g., an IPO or acquisition) that generates returns for investors. 

VC returns follow a power law distribution, which means one homerun investment in a portfolio of many companies can generate outsized returns for the entire fund. Funds often invest in a number of companies expecting that some could fail and hoping that others will experience large exits that “make” the fund. 

According to AngelList data, a venture-backed seed-stage startup has an estimated 1 in 40 shot—or 2.5% chance—of becoming a “unicorn” (company valued at over $1B) today.

Because venture capital funds invest in early-stage companies, these investments carry a high degree of risk. The high return potential for these investments help incentivize this risk taking.

What are the Different Stages of Venture Investment?

When a startup raises funding, the name of the fundraising round often implies the size/sophistication of the company. Common round names are:

  • Pre-seed
  • Seed
  • Series A
  • Series B
  • Series C
  • Series D

There’s no hard-and-fast rule for what qualifies as a “seed stage” or “Series D” company. A useful way to think about it is by looking at the average investment sizes for each round name.

average pre-money valuation by round

As the chart shows, startups increasingly raise larger rounds as they progress from pre-seed to Series D. 

Venture capital funds might have investment theses that target specific financing rounds. Some funds may primarily invest small amounts of capital in early-stage startups, while others may cut larger checks into later-stage businesses. 

What’s the Typical Lifecycle of a Venture Capital Fund?

Venture capital funds have a long lifetime because it usually takes years for the portfolio companies to exit.

Venture capital funds are typically structured under the assumption that fund managers will invest in new companies over a period of 2-3 years, deploy all (or nearly all) of the capital in a fund within 5 years, and return capital to investors within 10 years. Of course, there’s tremendous variety with investment periods and return periods in practice.

Who Can Invest in a Venture Capital Fund?

To invest in a venture capital fund, you must be an accredited investor (though some exceptions do exist). An accredited investor is a person or entity that satisfies one of the below:

  • Individual or joint net worth in excess of $1M (not including the value of a primary residence);
  • Individual income in excess of $200k or joint income in excess of $300k for the two most recent years, with a reasonable expectation of reaching this level in the current year; or
  • Individual holding a Series 7, 62, or 65 license.

An accredited investor with certain heightened investing or networth requirements can also classify as a “qualifying purchaser,” which provides access to investment opportunities exclusively reserved for qualified purchasers. 

Read our guide to accredited investors and qualified purchasers for more information.

How Much Money do You Need to Invest in a Venture Capital Fund?

Most venture capital funds have minimum investment amounts, but they can vary widely depending on the fund, its investment thesis, how much it's hoping to raise, etc. Some SPVs on AngelList have investment minimums as low as $1k, while Rolling Funds and Traditional Funds typically require a larger capital commitment (given they're investing in a portfolio of companies). One analysis found angel investors' average check size is between $25k - $100k.

How to Start a Venture Capital Fund

To start a venture capital fund, one must form a legal entity (more on this later) and raise capital from LPs.

Venture capitalists often get experience working with and investing in startups before managing venture capital funds, so that they can form an investment thesis and establish a network that can help them fundraise.

For example, an investor might have a portfolio of personal investments or a network of founders who rely on them for advice, or they might be closely involved with the people, organizations, and systems related to their investment thesis.

Someone starting a fund will need support in several legal and compliance disciplines—such as securities, employment, tax, and corporate laws, and some other skills, too (more on this later).

How is a Venture Capital Fund Structured?

venture capital fund structure
Source: NVCA
  • Management company. A management company is a business entity created by a venture firm’s general partners (GPs). It’s responsible for managing a venture firm’s operations across its funds. The management company collects fees and pays expenses. It also typically owns the fund’s trademark and brand. Single-member companies, which are most common for new GPs, are treated as “disregarded entities” under U.S. tax code, while multi-member companies are treated as partnerships.
  • General partner (GP). In a limited partnership, there must be at least one general partner  The GP is responsible for the active management of the fund and filing and signing the tax returns. The general partner has unlimited liability for the partnership.
  • Limited partners (LPs). The fund’s limited partners are passive investors in the fund. Examples of LPs include pension funds, foundations, insurance companies, and wealthy individuals. The liability of limited partners is capped at the amount of capital the limited partner contributed to the fund.
  • Portfolio companies. Companies the fund invests in.

Venture Capital Fund Documentation

Though requirements can vary, these are the typical documents you’ll need to set up and run your own VC fund (to learn more about this, see our guide to venture capital equity financing documents):

Fund documents:

  • Limited partnership agreement. This is an agreement that designates the general partner of the fund, lists the rights of the general and limited partners, and spells out the details of how a fund will operate. The terms in a fund’s LPA can be standard for everyone participating in the fund or customized for certain limited partners via a side letter or other separate agreement.
  • Private placement memorandum. Like a prospectus in a mutual fund, this is a disclosure document that’s given to investors.
  • Subscription agreement. This details the LP’s financial commitment and how contributions will work.

Deal-specific documents:

  • Term sheet. Lays out the terms under which the GP agrees to invest in the company.
  • Stock purchase agreement (SPA). Dictates the specific terms related to the sale of stock to investors.
  • Disclosure schedule for SPA. Provides exceptions or explanations to representations and warranties agreed upon in the SPA.
  • Voting agreement. Sets forth requirements as to how certain shareholders must vote their shares in certain instances.
  • Investor rights agreement (IRA). Breaks down the rights and privileges afforded to shareholders.
  • Right of first refusal / co-sale agreement. Provides the company the first opportunity to purchase the shares of an investor who wishes to sell them.
  • Certificate of incorporation.  Lays out the privileges and rights that come with owning stock in a corporation. In this case, a portfolio company.

 Tax documents: 

  • Schedule K-1. Funds issue the Schedule K-1 to LPs to record their investments and any reported earnings for the year.
  • Form 1065, Return of Partnership Income. This is how VC funds document and report income and expenses.

How do Venture Capital Funds Raise Capital?

Funds begin with a capital-raising period, where the venture capital firm seeks out LPs for the new fund. Depending on the firm’s reputation, market conditions, and fund strategy, the process can take months or even years.

Once the targeted funding amount’s been reached, the fund is typically closed to new investors.

How do Venture Capital Funds Deploy Capital?

VC funds typically make investments according to a particular thesis—for example, supporting startups in a particular stage, industry, or geography.

They typically have an initial investment window of 1-3 years in which they find and invest in companies. 

In a typical startup financing round, one fund will be the “lead” investor of the round. It’s the lead investor that often negotiates the price and other key terms of the round. Other funds and/or individual angel investors may choose to participate, usually on similar terms as the lead investor (though not always).

How do Venture Capital Funds Generate and Distribute Returns?

Typically, VCs generate returns when one of three things happens with one of their portfolio companies:

  • A portfolio company goes public through an initial public offering (IPO) on a public stock exchange;
  • A portfolio company undergoes a merger or acquisition; or
  • The fund manager sells the fund’s shares in a portfolio company to another entity.

Funds might wait for all of their positions to exit before distributing the returns to investors, or they might distribute returns as the liquidity events happen.

After fees and carried interest payment, limited partners take home the remainder of the returns. Typically, that remainder is 70-80% of the returns. 

Two and twenty (“2 and 20”) is a common fee arrangement in venture capital and private equity. The “two” means 2% of committed capital, a fairly standard management fee. The “twenty” refers to 20% of profits made by the fund. This is the “carry,” or carried interest, that GPs of venture capital firms typically earn.

GPs sometimes reinvest returns into the fund if a company exits earlier in a fund’s lifecycle. This practice, known as capital recycling, can provide more dry powder for future investments.

Venture Capital Management Fees

Venture capital funds typically charge an annual management fee based on a percentage (2% is common) of committed capital—though some funds use a percentage of returns earned or assets under management (AUM). The management fees help pay for the salaries and expenses of the general partner(s).

Sometimes, fees for large funds may only be charged on invested capital or decline after a certain number of years.

Hedge Fund vs. Venture Capital Fund

Venture investing is different from other types of equity financing—like mutual funds, the stock market, and hedge funds—because VCs focus on a very specific type of investment. 

With the stock market and mutual funds, investors back companies that tend to be much more mature and proven. Hedge funds typically invest across many investment categories. 

This focus on early-stage by VCs companies produces high-risk/high-return profiles compared to other asset classes.

Venture Capital Funds on AngelList

AngelList offers investors a way to gain exposure to the startup ecosystem and venture capital deals. 

Investors can start or invest in a venture capital fund on AngelList using one of three main structures:

  • Traditional Fund. A pooled fund for investing in multiple startups over a 10-year investment horizon.
  • Syndicates. A fund set up to invest in a single company.
  • Rolling Funds. A fund that allows investors to subscribe to quarterly investment vehicles and adjust their commitment size as their goals evolve.

To learn more, visit our website.

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