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.

Understanding 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. 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.

Venture Capital Firms and Funds

Venture capitalists and venture capital firms fund all different types of businesses from dotcom companies to biotech and peer-to-peer finance companies. They generally open up a fund, take in money from high-net-worth individuals, companies, and other funds, then invest that money into a number of smaller startup companies.

Venture capital funds are raising more money than ever before. According to financial data and software company PitchBook, the venture capital industry invested $130.9 billion in American startups by the end of 2018. The total number of venture capital deals for the year totaled 8,948—an all-time high, PitchBook reported. Two of the year's biggest deals included a $1.3 billion investment round into Epic Games, as well as Instacart's $871.0 million Series F.

The report also cited an increase in the size of funds, with the median fund size rounding out to about $82 million, while 11 funds closed out the year with $1 billion in commitments including those from Tiger Global, Bessemer Partners, and GGV.

Key Takeaways

  • Venture capital funds manage the money of investors who want private equity stakes in startup and small- to medium-sized enterprises.
  • Unlike mutual funds and hedge funds, venture capital funds focus on early-stage investment, and high-growth firms that are risky, and have long investment horizons.
  • Venture capital funds are considered seed money or early-stage capital.
  • Investors make a return when a portfolio company exits, either through an IPO, merger, or acquisition.

Operating 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.

Venture capital investment is considered seed or early-stage capital.

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.

Venture Capital Fund Returns

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%—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%.