I often have founders ask me about raising capital or structuring their shares. I love to help founding teams — over coffee or in a two-hour session — and in those sessions I've heard myself explain how venture capital works again and again. So I thought I'd write it down: one place I can point founders to when they reach out.
If you are a startup founder considering raising money from outside sources like venture capital (or angel investors), it is smart to understand how the other side of the table makes money. VC is just one source of capital — there are grants, crowdsourcing, innovation loans, revenue-based financing, etc. Or actual revenue! But we will focus on VC funds here.
Because once you have a VC fund on board, you are married, and dancing together, in the rhythm that VC funds need to dance in.
The most important things to realise:
- You will need to grow very fast (10× in 5 years), in order to grow big: tens of million in revenue, exit of hundreds of millions.
- You will sell the company within around 4 to 8 years, or get listed on the stock exchange ("go public," or "IPO").
- The fund is on board for the life of the company: consider it a marriage, for better and for worse.
This means you need the ambition to go on a rocket ship style journey and then sell the company when you attract VC funding, because this is what you will sign up for.
It's possible a fund will want you to grow faster than you think is right or possible, and it can mean they will want to sell when you don't want to at a certain point. But this is the ambition you agree on for your marriage between VC and founders.
How do VCs make money?
What you will have thought of is that a VC makes money when companies do well and the shares are worth more. But how does it pay its people until that time? And where does a VC's money come from? Let's dive in.
VC firms (that manage VC funds) make money in two ways:
- Management fee — money for managing the fund. As a ballpark, this is often around 2% of the total fund per year.
- Carried interest — money when companies are sold at a much higher price than the value when the fund invested — not individual companies, but over the entire portfolio. Then the fund creates a good return for their investors (more about that below). After the investors have at least got their money back, the people running the fund (partners) get a percentage of the extra value created so fund management and their investors aim for the same goals. This is often around 20% (again simplified, there are so called hurdles and catchups, but that is too detailed for the purpose of this post).
Where does a VC fund's money come from?
Before we go deeper into examples of making money (or not), let's look at where a VC's money comes from. Yes — if you didn't know, VC funds have investors themselves. These are called LPs (limited partners). They are usually institutions or individuals that invest some of their money in low-risk things (bonds, real estate) and some in higher-risk things (a VC fund). So VCs need to fundraise too. Partners of the VC firm ("general partners") are usually also expected to put in 1-5% of the fund from their own means.
This is not unlike a startup raising money in some aspects: a fund needs to pitch to a lot of potential investors, they will hear "no" more often than "yes," and it can take months or even years to close the investment. This interview explains it well.
VC making money — an example
Back to how VCs make money: they get part of the success when companies become much more valuable, and they get money to run the process.
When we talk about "a VC," we really mean two things:
- The financial fund — or VC fund, almost all money from investors into that fund (LPs).
- The people running the fund — or VC firm, general partners (GPs).
(This is a bit simplified.)
The people running the fund make money when companies become more valuable through carried interest: they get a percentage of the value increase of the total fund — funded by their investors, only a few percent from the GPs own money.
To understand carried interest, let's look at an example (built from AngelList on carried interest and input from Curiosity VC's partner Herman Kienhuis):
A 30 mln fund has one unicorn exit (and no other exits), in which they invested 500K and got 5%, so the fund earns 5% of 1B so 50m - 500K investment = 49.5M value created. The fund first has to distribute 36m to its LP (principal plus minimum return hurdle of in this case 20%), after which there is 14M left. Of this the GPs get 20% = 2.8M. The LP's get 47.2M.
Note that all of this is about the returns of the entire fund, not about individual companies returns.
Do VCs make 100× their money?
You might read about the most successful VC investments where a fund makes 100 or 1,000 times what it put in.
But reality is more complex — as usual. You don't read about the cases where they lost all the money. Choosing the right investments 5–10 years before is the hard part (actually one of a few hard parts.)
If 6 out of 10 investments create no return, the remaining 4 need to become 5× as valuable in the period of the fund (often 10 years) to double the amount of money that went into the fund.
(Again a simplification: LP money doesn't all go into the fund until deals are closed, so it isn't in the VC's bank account for 10 years. That plays a huge role in a VC's and LP's math, but for explaining returns to founders I'm keeping it out here.)
Doubling the fund in 10 years would not be very good. If you'd gotten 7% interest on a bank account for ten years, your money would also have doubled (1.07^10 ≈ 2.0).
Because VC investments are higher risk, they need to try to create a higher return as well. As you might know, lower-risk investments mean lower returns — less risk of losing money, higher certainty of a given return or "interest."
To get higher returns, you need to accept a higher risk profile too.
(Let me know if you'd like more explanation on risk and return.)
Simply put, the "interest" you would compare this with — the return on the money you put in, per year — is called IRR. Titan has a more in-depth explanation of venture capital IRR. In the above example, an IRR of 7% would double your money in 10 years.
As a potential LP with a lot of money, you can invest in very safe things with guaranteed returns around 2%, or in higher-risk investments that might return 20% per year but also risk returning nothing.
What is a good return and what VC returns are really created?
Funds in Europe over ten years have created IRRs of 17% - 21% while US funds have created IRRs of 13% - 18%. (Invest Europe / Cambridge Associates methodology (cited in State of European Tech, via Sifted, see more data here, thanks Herman for pointing me to those sources). The best 10% have over 20% IRR.
If we look what that means over the lifetime of a fund: in 8 years, 15% IRR means returning more than 3×; 20% IRR means more than 4×; 30% means more than 8×. (Note: purposefully again simplifying, leaving costs out for example).
What return is expected from you as a portfolio company?
Let's assume a fund aimed for 20% IRR (you can compare this to getting 20% interest if this were a bank account).
To get 20% per year return, in 8 years a fund needs to get roughly 4× the money back that went in in a slightly too simplified formula (1.2^8 ≈ 4.3). In reality, as not all money immediately goes in and not all returns are only at 8/9 years, it is closer to 3X.
Therefore a fund wants you to aim for at least 10× their money back in around ten years — or "die trying" (as a company). So 5× is not good enough.
Much of the above is quite simplified (warning ;-)) but I want you to understand these basics.
And these aren't hypothetical numbers. Looking at data spanning two decades, hundreds of European VC funds, and thousands of EIF-backed investments: 57% of exits returned less than a quarter of what was invested, and 70% returned less than the original investment — a loss. Just 4% of exits returned more than 5×, and that same 4% generated almost half of all the money the entire sample returned. That's not a scare number — it's the actual shape of the portfolio math above.
If we do quite fine, a VC won't want to sell us, right?
Because a VC's entire structure and business model is about returning money to their investors in ~10 years, they need to sell their shares in your company to get that money back with a return.
Until then — and often longer — the investors in the fund (the LPs) cannot withdraw their money like from a savings account. They only get their money back, hopefully with a return, when the fund closes after ~10 years.
(Very simplified — let me know if you want more nuance on how this actually works.)
So getting dividends from a company at a nice size might work for your financial wishes; it is not what creates returns that work for a VC.
For a VC, the company needs to be sold or go public and sell shares on the stock exchange. It is possible for the VC to sell their shares to another investor, or have the company buy back their shares — but that leads to another investor at the table in "your" company and those transactions are not seen as very attractive by VCs.
I write "your" company with quotes around your, because when you have new shareholders outside of the founders, it goes from just you — from my to ours.
What if founders and investors have different definitions of success?
One of the key things to understand is that a VC has more than one chance this decade to "hit a homerun" and have a company be >20× worth what it is today, because it generally has a portfolio of, say, 20 companies it invested in.
If you are worth 5× more than when a fund invested, that can mean success for you: if you'd sell now, you would be independently wealthy and could start something new.
But, as we went through, because of the high risk — and therefore a number of portfolio companies failing — they need to earn that money back with the successful ones. So 5× won't be enough. Your investor will push for more growth, and for you this can sometimes feel like a game of "double or nothing" every year.
This is a bit of an exaggeration to make the following point: this "double or nothing" risks the "nothing" for your only company, while the fund risks it for one of their twenty companies.
This is not because they are bad people, but because they need to earn the money back on the companies that don't make it. Otherwise they would have lost the money trusted to them by their investors — and you yourself wouldn't put money in a savings account you couldn't withdraw for ten years that then paid 0% interest, right?
When you accept investment from a VC fund, you need to understand their mechanics. Explaining how you want a scenario that works for you but not for them won't work. That would be naive and actually unfair to them. The fund needs to get their potential 10× value. You need to accept that your incentives may not be always fully aligned there.
This is why you need to understand what dance you agree to play once you take the route of VC funding. This is my main motivation for writing this: so founders know what they get into — or don't get into.
Can we reduce the difference in incentives?
A way to decrease this difference in incentive is to sell some of your shares as a founder in a later investment round. This is called a secondary. This is a sensitive topic for investors, the younger the company, the less popular this is for investors.
Many later-stage funds will be open to you selling some of your shares in an investment round when they invest. I have heard investors were open to letting founders sell "enough to buy a house and not worry about kids' university tuition — but not enough to live on a yacht and not work for the rest of your life".
Understanding your partner makes the relationship work
Now that we've explained some of the basics of how VC funds work, and why they need to steer towards you potentially getting them >10× their money back, you can go into a fundraising situation knowing better what to expect from the future.
I hope this helped you as a founder understand VC funds a bit better. Let me know if this helped.
Big thanks for Curiosity VC's Herman Kienhuis and SHIFT invest's Thijs Gitmans for reviewing this, adding sources and bringing examples to a next level!