What are Venture Capital Funds
Venture capital funds are investment funds that manage the money of investors who seek private equity stakes in startup and small- to medium-sized enterprises with strong growth potential. These investments are generally characterized as high-risk/high-return opportunities. In the past, venture capital investments were only accessible to professional venture capitalists, although now accredited investors have a greater ability to take part in venture capital investments.
BREAKING DOWN Venture Capital Funds
Venture capital is a type of equity financing that gives entrepreneurial or other small companies the ability to raise funding. Venture capital funds are private equity investment vehicles that seek to invest in firms that have high-risk/high-return profiles, based on a company's size, assets and stage of product development.
Venture capital funds differ from mutual funds and hedge funds in that they focus on a very specific type of early-stage investment. All firms that receive venture capital investments have high-growth potential, are risky and have a long investment horizon. Further, venture capital funds take a more active role in their investments by providing guidance and often holding a board seat.
Venture capital funds have portfolio returns that resemble a barbell approach to investing. Many of these funds make small bets on a wide variety of young startups, believing that at least one will achieve high growth and reward the fund with a comparatively large payout at the end. This allows the fund to mitigate the risk that some investments will fold.
The Operation of a Venture Capital Fund
Venture capital investments are considered either seed capital, early-stage capital or expansion-stage financing depending on the maturity of the business at the time of the investment. However, regardless of the investment stage, all venture capital funds operate in much the same way.
First, like all funds, venture capital funds must raise money prior to making any investments. A prospectus is given to potential investors of the fund who then commit money to that fund. All potential investors who make a commitment are called by the fund's operators and individual investment amounts are finalized.
From there, the venture capital fund seeks private equity investments that have the potential of generating positive returns for its investors. This normally means the fund's manager or managers review hundreds of business plans in search of potentially high-growth companies. The fund managers make investment decisions based on the prospectus and the expectations of the fund's investors. After an investment is made, the fund charges an annual management fee of around 2%, and some funds may not charge a fee. The management fees help pay for the salaries and expenses of the general partner. Sometimes, fees for large funds may only be charged on invested capital or decline after a certain number of years.
Investors of a venture capital fund make returns when a portfolio company exits, either in an IPO or a merger and acquisition. If a profit is made off the exit, the fund also keeps a percentage of the profits -- typically around 20 percent -- in addition to the annual management fee.
Though the expected return varies based on industry and risk profile, venture capital funds typically aim for a gross internal rate of return around 30 percent.