VC funds don’t always receive the same attention as their colleagues in the private equity and broader asset management space, and historically they’ve sometimes been seen as a bit mysterious. Here is an overview of exactly what venture capital funds are, how they work, and the different types of VC funds, while also providing some advice on how family offices can go about choosing a venture capital fund to invest in.

Venture Capital funds (VC funds) have become one of the most exciting areas to invest in the last few years, deploying billions of dollars of finance into innovative early-stage businesses. Last year, global venture investment totalled $643 billion, almost double the 2020 figure, and ten times the size of the market just a decade earlier. Most of this cash originates from one of the thousands of VC funds around the world.

But, as one of the smaller asset classes, venture capital funds don’t always receive the same level of attention as their colleagues in the private equity and broader asset management space, and historically they’ve sometimes been seen as a bit mysterious. Here is an overview of exactly what constitutes a venture capital fund, how venture capital funds work, and the different types of venture capital funds out there, while also providing some advice on how family offices should go about choosing a venture capital fund to invest in.

What is a venture capital fund?

In essence, a venture fund is a pool of capital that is specifically aimed at investing in early-stage companies with strong growth potential. Investors in a VC fund are called limited partners (LPs), while the individual or company that manages and deploys the funds is called the General Partner (GP). GPs deploy capital to acquire stakes in startup companies, with a view to making a high return when the company exits – whether through an acquisition or an IPO.

VC funds are considered a high-risk investment, due to the potential high failure rate of early-stage businesses – VC funds often make the majority of their returns from just 20% of their deals. However, VCs who get it right can make considerable returns by taking a strategic, intelligent approach to supporting high-potential young companies – good VCs typically expect a ten-times return of capital over five years. It takes skill and experience to build and nurture a balanced and diverse venture portfolio. Patience is also vital, with funds generally taking around five years to deliver returns.

VC funds are typically managed by specialist VC firms, which can vary in size from one or two partners, and up to a couple of hundred employees. While the big, established names might have a higher profile, a younger, lesser-known fund can offer greater access to deals, VC principals and startup founders themselves.

How do venture capital funds work?

To launch a VC fund, a GP must first raise the necessary capital through family offices, high-net-worth individuals, and institutional investors, such as pension funds and investment banks. GPs must demonstrate to potential LPs how their strategy will deliver the expected returns through their skill in choosing the right startups to invest in, as well as their ability to nurture them throughout their growth journey, while also managing and balancing the entire portfolio successfully.

Each VC fund has its own investment strategy and criteria, in terms of the sectors, business models and types of technology it invests in, as well as the size of investments that it makes – and therefore the funding stages it will target. VC funding stages typically include Pre-Seed, Seed, Series A, Series B, Series C, and sometimes D and E, and at each stage the amount being raised increases, ranging from a $500,000 to $2m seed round, up to hundreds of millions for a Series C or above. VC funds will typically focus on a specific stage, or a number of stages, of the startup funding journey. Generally, the earlier they choose to invest, the greater the risk, but also the greater the chance of making significant returns.

When it comes to their own compensation, VC funds make money in two ways. Firstly, they charge a management fee, which is typically 2% per year of the value of the fund, to cover their salaries and operational expenses. Secondly, they earn what is called carried interest, typically at 20%. So, if a fund’s size is $50mm, and the total return generated is $150mm (3x return), the firm will earn 20% on every dollar earned of the $100m profits generated. Once a fund is deployed and growing successfully, a firm will generally look to raise a follow-up fund, thereby managing multiple funds.

How do venture funds choose where to invest?

VC funds typically receive thousands of approaches and pitches from startups looking for investment. Their job is to filter out the most promising deals, by having a clear strategy and criteria for investment, building a strong brand, reputation, and network, and doing their own in-depth market and opportunity analysis.

Once a potential investment is identified, VCs undertake extensive due diligence of a startup’s company accounts, business plan, and crucially the business founders, to ensure that there is a shared vision for the future of the company, and the two parties can work together. Unlike some other areas of asset management and investment, VCs and startup founders are signing up for a long-term working relationship, where VCs take an active role in helping to grow the business. So, it is vital that they can get along and collaborate effectively.

Negotiating a deal

Alongside due diligence, VC funds must work with startup founders to negotiate deal terms that work for both parties. Key components include agreeing on a valuation for the business, the amount that the VC fund will invest, and the equity ownership as a result. There are also decisions to be made regarding liquidation preferences, involvement of VCs in future funding rounds, as well as the boardroom makeup and voting rights. VCs will usually take a seat on the company board as part of the deal.

An active role

Once a deal is formalised, VCs and startups are usually together for around five years or more, and most will have a close working relationship during that time. The most effective venture firms take a hands-on role with startups, helping them to overcome challenges and maximise growth. Early-stage companies need a lot of support across numerous areas of the business, from recruitment to business development, market fit to operations, and orchestrating future funding rounds. VC firms nurture their own networks, as well as draw on their own experience, to provide guidance, advice, and hands-on support.

How do family offices choose a venture capital fund?

Venture investment is increasingly popular amongst family offices, and while many family offices like to make investments directly, the majority choose to work with VC funds or take a hybrid approach. Building and managing a VC portfolio in-house is expensive, and time-consuming, requiring specialist skills and experience. In contrast, VC firms offer a one-stop-shop, with the talent and knowledge and the ability to spread their risk over a whole portfolio.

Choosing the right VC partner is vital. Many family offices look for referrals from their existing networks, but it is important to shop around to find the right strategic fit. Aim to meet a variety of funds in the same peer group to understand their strategy and capabilities, as well as the personal chemistry and whether you can work together in a mutually productive and beneficial way. Ask questions about the investment thesis, plans to grow, their approach to nurturing portfolio companies, what their deal flow is like, and of course their past performance.

Putting the time in upfront will ensure that you achieve not just your financial objectives, but also use your funds to support the kinds of businesses and founders that fit with your own interests and investment philosophy