How Do Venture Funds Work?

Venture Capital Recap

In my previous piece, I went over the basics of venture capital. To recap, venture capital is a form of private equity in which investors provide (generally) early-stage companies capital or financing in exchange for equity in companies they believe have long-term growth potential. For example: when Uber was in its infancy in 2009-2011, investors like Rob Hayes of legendary venture firm First Round Capital provided and led Uber’s (then UberCab) first investment round in exchange for an ownership stake and helped propel Uber to the behemoth it is today. There are numerous pieces at play in venture capital, and the first we’ll dive deeper into is the venture fund and how it works.

How Do Venture Funds Work?

The founders of venture firms are the General Partners (GPs) and the investors in venture funds are called Limited Partners (LPs). LPs are are high net-worth individuals, family offices, foundations, university endowments, big corporations, pension funds, and funds of funds.

Courtesy of Ahmad Takatkah, here is the most used fund structure:

The important bits from the diagram is that LPs commit capital to a specific fund (whether it be Fund I, Fund II, etc..) that then invests in portfolio companies. The fund (in this fictional example, Innovate Ventures Fund I L.P.) that invests in portfolio companies pays management fees (traditionally 2%, but that figure is probably closer to 1% nowadays) to Innovate Ventures Management LLC which is the management company where the partners are physically based or where they operate. The last major legal entity in this example is Innovate Partners I GP which is where the partners contribute their own capital i.e., “have their own skin in the game”, and are also paid a 20% carry or profits (traditionally) from the fund (Innovate Ventures Fund I). The VC firm in this example, Innovate Ventures, is the combination of all the legal entities.

This is the most commonly used fund structure in venture capital. The structure gets a little more complicated if taking into account non-US based LPs, SPVs (special purpose vehicles), and co-investing, but for the purposes of this article, we’re rolling with the most common venture capital fund structure.

How Does This Relate to Equity Crowdfunding?

Given we focus on equity crowdfunding, how does understanding the intricacies of venture funds relate to us? My goal is to highlight the pros and cons of venture capital and equity crowdfunding, so let’s dive into it.

Pros of Venture Capital

VC guidance and expertise
Network opportunities
Large amounts of stable, institutional capital

Cons of Venture Capital

Loss of equity/ownership
Over-involvement in company activities
Difficult to obtain

With equity crowdfunding, potential investors in a startup/early-stage company truly believe in their investments. On the investor side, you also get to avoid the complex fund structure associated with venture capital and can easily invest in a company of your choosing. The downsides, however, of equity crowdfunding are also apparent. A VC investor generally gets some say in their investments and as an equity crowdfunded investor, your say and involvement are minimal.

Additionally, the burden of due diligence obviously falls onto individual investors who may or may not have the domain knowledge and resources needed to vet a startup raising on the various platforms out there. Even an investor or supporter of a company wants to invest in something they believe in, should they do so without institutional-grade analysis? We at KingsCrowd want to change that and provide equity crowdfunding investors world-class research that properly vets and rates startups raising on equity crowdfunding platforms.