How Venture Capital Funds works-2?

Venture Capital (VC) funds play a crucial role in fueling innovation and entrepreneurship by investing in early-stage and growth companies. Understanding how these funds work is essential for entrepreneurs, investors, and anyone interested in the startup ecosystem.

There are 3 basic entities that make up the fund

a. the management company: owned by senior partners (it is the franchise of the fund, never dies). This is the entity owned by the fund’s senior partners. It operates as the ongoing business franchise of the VC firm, managing the fund’s day-to-day activities and making investment decisions. The management company typically remains active even as individual funds close and new ones launch.

b. limited partnership: the actual investors (they provide capital to venture capital firms. LPs are passive investors and have limited involvement in the day-to-day operations of a venture capital firm). The limited partners are the investors who provide capital to the fund. LPs are passive and do not participate in the fund’s daily management. Their liability is limited to the amount they invest.

c. general partnership: typically establishes the fund. The GP has unlimited liability and takes responsibility for the fund’s investments and operations. 

Who is a GP/LP
How firms raise money

● VCs raise money from a variety of sources/entities, including govt, and corporation pension funds, large corporations, banks, professional institutional investors, individual accredited investors, educational endowments, etc. 

● arrangement between the VC and their investors is subject to the Limited Partnership Agreement - LPA

What is the Limited Partnership Agreement (LPA) ?

It is a legally binding contract that outlines the terms, conditions, rights, and responsibilities of the partners in a limited partnership. The LPA defines the roles and responsibilities of the general partners and limited partners. General partners manage the day-to-day operations of the partnership and have unlimited liability for the partnership's obligations. Limited partners contribute capital but have limited liability and typically have no direct involvement in the management of the partnership. The LPA outlines how management decisions will be made. General partners usually have the authority to make operational decisions, while certain major decisions might require the consent of all partners or a specific majority. The LPA also outlines decision-making processes: GPs typically handle operational decisions, while major choices might require LP approval.

How VCs make money: 

Management fees: 

● VCs’ salaries come from their fund’s management fees - which is usually a percentage of the total amount of money committed to a fund- usually between 1.5 - 2.5%. 

● the fees are taken annually (paid out quarterly or semiannually)

● if a firm raises a fund every 3 years, it has a new management fee that adds to its old management fee. i.e. 2% of total committed capital across all funds. 

● the management fee is paid annually. i.e. 2% of the committed capital every year!, thus, for 10yrs fund, this can run up to 20% of the total committed capital

● the management fee is independent of the investing success.

● VCs are allowed to recycle their management fee and subsequently reinvest it up to the total of $100m. 

 Carried Interest: 

● carry is the profit that VCs get after returning money to their investors (the LPs). 

● For example

a. $100m fund example, VCs receive their carry after they have returned $100m to the LPs. 

b. Most VCs get 20% of the profits after returning capital (i.e. a 20% carry), although some long standing or extremely successful funds take up to 30% of the profits. 

c. example: $100m fund returns 3x i.e. $300m. The first $100m goes back to the LPs, and the remaining profit, or $200m is split 80% ($160) to the LPs and 20% ($40m) to the GPs.

d. the $15m management fee can be viewed as a prepayment on carry since it is essentially getting reinvested from proceeds of the fund.

● clawback: 

a. assume $100m fund, and the VC has called only half of the fund ($50m). 

b. if the $50m invested so far returns $80m, the fund is in a profit situation where $50m has been returned and there is a $30m in profit that the VCs may have the right to take their carry on. 

c. the VCs happily pocket their $6m, assuming the carry is 20%. 

d. where the VCs call and invest the rest of the fund and its a bust, returning a total of only $100m, but returned a total of only $100m; at the end of the fund, the VCs would have invested $100m and as a result should get no carry. 

e. the initial $6m will be clawed back from the VCs and given back to the LPs. It is not so practical. The LPs don't care, they want the $6m that is owed to them and the LPA will typically state that each partner is liable for the full amount, regardless of what they actually received in profit distributions. 

● commitment period - 5 years 

● investment term- 10 years with 2 one-year options to extend,

Clawback risks: 

There is the clawback risk, if the VC calls and invests the rest of the fund and its a bust, returning a total of $500m, at the end of the fund, the VC would have invested $500m and have made only $500m, and the VC should not get any carry. This means if early profits result in carry payments but later investments lose money, VCs might need to return carry to LPs.

Thus, the initial 10m will be clawed back from the VC.  - if you take it

For instance, if a fund called half its capital and returned profits allowing carry payments, but the total return at the end only matches the capital invested, the initially received carry must be “clawed back” to ensure LPs are fully repaid. The LPA enforces clawback to protect LPs’ interests.

Fund Duration and Terms

• Commitment Period: Typically 5 years for making investments.

• Investment Term: Usually 10 years, with options to extend by 1-2 years.

Waterfall Structure

The waterfall structure determines how profits are distributed between LPs and GPs.. Theterms "European waterfall structure" and "American waterfall structure" are terminologies often used in the context of private equity and venture capital fund distribution models. They refer to different methods of distributing profits to fund investors, typically limited partners (LPs). Here's an explanation of each:

1. European Waterfall Structure:

○ Sequential Distribution: In a European waterfall structure, profits are distributed sequentially, meaning there is a specific order in which distributions occur. LPs receive their full capital and preferred returns before any carry is paid to GPs.

○ Preferred Return First: Typically, the first distribution is made to investors to provide them with a preferred return on their investments. This preferred return is usually a fixed percentage (e.g., 8%) or a hurdle rate.

○ Carried Interest: After the preferred return has been met, any remaining profits are then split between the fund managers (general partners or GPs) and the investors. The fund managers receive a share known as carried interest, often around 20%.

○ Emphasis on Protecting Investors: The European waterfall structure is designed to prioritize protecting investor capital by ensuring they receive their preferred return before fund managers receive their share of profits.

2. American Waterfall Structure:

○ Parallel Distribution: In contrast, an American waterfall structure distributes profits in parallel, meaning both investors and fund managers receive their share simultaneously. GPs can receive carry on individual deals even if the entire fund hasn’t fully returned LP capital.

○ Preferred Return: Similar to the European model, there may be a preferred return for investors, but it is

Fundraising Tips:

Fundraising materials 

● summary  - simple email or elevator pitch (one to three paragraphs that describe the product, team and the business very directly). 

● executive summary: short concise description of the idea, product, team, and business. this is the basis of the company’s first impression - work hard on this doc (1 - 3 pages). It is also a direct indication of your communication skills. Include the problem you are solving and why it is important to solve.

● Investor presentation: usually like 10 - 20 page PPT consisting of a substantive overview of the business. goal is to communicate the same information from the executive summary, often with more examples, but using a visual presentation. 

● business plan or private placement memorandum (just a traditional business plan wrapped in legal disclaimers that are often as long as the plan itself)- focus on quality and content: detailed info about the business.

Due Diligence Materials

● cap table, material customer agreements, employment agreements, board meeting minutes, etc

● organise these docs for quick delivery prior to going out to raise, so you don't slow down the process when an investor asks for them. 

● never try to hide anything with any of these fundraising materials.

● full disclosure is key

Closing the deal 

● the most important part of the fundraising process is to close the deal, raise the money and get back to running your business.

● closing the deal is divided into 2; 

a. signing of the documents: 

b. receiving the cash 

Do investors have to pay all their commitment fees at once to the VC Firm?

In many cases, investors do not have to pay their entire commitment amount upfront; rather, they commit to providing the capital when it is needed by the VC fund to make investments in portfolio companies.  VCs do this through capital calls schedule to its limited partners.  This call outlines the due date by which the committed capital should be provided. This information is usually provided during the investment discussions with investors/limited partners. In Future Africa, for our Fund III, we have provided this schedule to our LPs for their capital contribution:

What Next After the VC firm has received cash from investors? 

Deal Sourcing 

VC firms actively seek out investment opportunities through various means, including networking events, referrals from their portfolio companies, entrepreneur pitches, industry conferences, and startup accelerators. They evaluate numerous startups to identify those with the most promising potential for growth and returns. : Each VC fund has a specific investment strategy or focus. This strategy could be based on industry sectors (e.g., technology, healthcare, clean energy), stages of company development (early-stage, growth-stage), geographical regions, or a combination of these factors. 

The Investment team within Future Africa are in charge of sourcing for deals and if found, the following steps follow:

Due Diligence: Once a potential investment opportunity is identified, the VC team conducts thorough due diligence. This involves researching the market, evaluating the business model, assessing the team's capabilities, scrutinizing the technology or product, and analyzing financial projections. The goal is to assess the risks and potential rewards of the investment.

Investment Decision: After completing due diligence, the VC team decides whether to invest in the startup. If they decide to proceed, they negotiate the terms of the investment, including the amount of funding, the valuation of the company, and the ownership stake the VC fund will receive in return.

 Analyse Market Strategy: 

Exit Strategies: The ultimate goal of VC investment is to achieve a successful exit that generates returns for the fund's investors. Common exit strategies include initial public offerings (IPOs), where the startup's shares become publicly traded on a stock exchange, and acquisitions, where larger companies buy out the startup. When successful exits occur, the VC fund realizes a return on its investment, which is distributed to its investors. : When a VC fund achieves profitable exits, the returns are distributed among the fund's investors based on their proportional contributions. VC funds typically charge management fees and carry fees. Management fees cover operational expenses, while carry fees are a percentage of the profits earned from successful exits.

Additional Considerations

• Recycling Capital: Some funds reinvest proceeds from exited investments back into new opportunities.

• Follow-on Investments: Funds often reserve capital to support portfolio companies through multiple funding rounds.

• Fund Governance: Advisory committees or boards may oversee conflicts of interest and fund operations.