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The VCs and their partners
Venture capital general partners (also known as “venture capitalists” or “VCs”) may be former chief executives at firms similar to those which the partnership funds. Investors in venture capital funds (limited partners) are typically large institutions with large amounts of available capital, such as state and private pension funds, university endowments, insurance companies, and pooled investment vehicles.
Other positions at venture capital firms include venture partners and entrepreneur-in-residence (EIR). Venture partners “bring in deals” and receive income only on deals they work on (as opposed to general partners who receive income on all deals). EIRs are experts in a particular domain and perform due dilligence on potential deals. EIRs are engaged by VC firms temporarily (six to 18 months) and are expected to develop and pitch startup ideas to their host firm (although neither party is bound to work with each other). Some EIRs move on to roles such as Chief Technology Officer (CTO) at a portfolio company.
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Fixed-lifetime funds
Most venture capital funds have a fixed life of ten years. This model was pioneered by some of the most successful funds in Silicon Valley through the 1980s to invest in technological trends broadly but only during their period of ascendance, and to cut exposure to management and marketing risks of any individual firm or its product.
In such a fund, the investors have a fixed commitment to the fund that is “called down” by the VCs over time as the fund makes its investments. In a typical venture capital fund, the VCs receive an annual management fee equal to 2% of the committed capital to the fund and 20% of the net profits of the fund (“two and 20”). Because a fund may run out of capital prior to the end of its life, larger VCs usually have several overlapping funds at the same time; this lets the larger firm keep specialists in all stage of the development of firms almost constantly engaged. Smaller firms tend to thrive or fail with their initial industry contacts; by the time the fund cashes out, an entirely-new generation of technologies and people is ascending, whom the general partners may not know well, and so it is prudent to reassess and shift industries or personnel rather than attempt to simply invest more in the industry or people the partners already know.
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How and why VCs invest
Investments by a venture capital fund can take the form of either preferred stock equity or a combination of equity and debt obligation, often with convertible debt instruments that become equity if a certain level of risk is exceeded. The common stock is often reserved by covenant for a future buyout, as VC investment criteria usually include a planned exit event (an IPO or acquisition), normally within three to seven years.
In most cases, one or more general partners of the investing fund joins the Board of Directors of the new venture, and will often help to recruit personnel to key management positions.
Venture capital is not suitable for many entrepreneurs. Venture capitalists are very selective in deciding what to invest in; as a rule of thumb, a fund invests only in about one in four hundred opportunities presented to it. They are most interested in ventures with high growth potential, as only such opportunities are likely capable of providing the financial returns and successful exit event within the required timeframe that venture capitalists expect. Because of such expectations, most venture funding goes into companies in the fast-growing technology and life sciences or biotechnology fields.
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Winners and losers
Venture capitalists hope to be able to sell their stock, warrants, options, convertibles, or other forms of equity in three to seven years, at or after an exit event; this is referred to as harvesting. Venture capitalists know that not all their investments will pay off. The failure rate of investments can be high; anywhere from 20% to 90% of the enterprises funded fail to return the invested capital. In case a venture fails, then the entire funding by the venture capitalist is written off.
Many venture capitalists try to mitigate the risk of failure through diversification. They invest in companies in different industries and different countries so that the risk across their portfolio is minimized. Others concentrate their investments in the industry that they are familiar with. In either case, they usually work on the assumption that for every ten investments they make, two will be failures, two will be successful, and six will be marginally successful. They expect that the two successes will pay for the time given to, and risk exposure of the other eight. In good times, the funds that do succeed may offer returns of 300 to 1000% to investors.