For those who don’t have a background in finance, or who simply don’t have much investment experience, understanding how venture capital funds work can be (understandably) a bit confusing. While they are mechanically similar to traditional investment funds, like hedge funds and mutual funds, their aims and strategy are quite different.
What is an Investment Fund?
Before jumping into venture capital funds, it’s important to know how general investment funds work. An investment fund is made up of capital supplied by a pool of investors and then used to collectively purchase various securities. Under this structure, each investor keeps ownership and control of their own shares. For investors who prefer a more hands-off approach, investment funds can offer access to a wide variety of investment opportunities as well as lower investment fees than a single investor may be able to get independently.
An important feature to note is that the investors do not decide how the fund will be allocated – that is the responsibility of the fund manager.
What is a Venture Capital Fund?
A venture capital fund is a type of investment fund for investors looking to make private equity investments in early or late-stage startups.
Working under the assumption that not all of the startups invested in will achieve success, venture capital funds mitigate risk by investing across a variety of small companies in the hopes that at least one will result in a portfolio return. An investor who is seeking a high-risk, potentially high-return opportunity would be well-suited for this type of investment.
How are Venture Capital Funds Different?
Unlike mutual funds and hedge funds, venture funds focus on early-stage and late-stage investments that either have the potential for rapid-growth or are on track to make an exit within the next three to ten years depending on the fund’s thesis. Naturally, these tend to be riskier investments. For venture funds focused on earlier-stage companies, it’s also very common for the fund to provide guidance, and they may even hold a seat on the boards of their portfolio companies.
While some venture capital funds take a broader approach to the types of investments they make, other funds are very niche, opting to focus in a specific sector. From tech and real estate to quarry mining and cannabis, there are funds for any and every interest.
How Venture Capital Funds Operate
Of course, before any investments can be made, a venture capital fund must first raise money to invest. This is the capital raising stage. The length of this stage varies depending on who is raising money, and what the funds will be used for. Once the fund has been fully subscribed (i.e., all the money has been raised), the investing stage begins.
The time it takes the fund to determine how the fund will be allocated can vary greatly; at MicroVentures, we aim to have all our funds invested within 18 months. Once the first investment has been made, investors will begin receiving quarterly updates the first quarter following the initial investment.
After the fund has been fully invested, and assuming the fund has met its goals, the harvesting period begins. This is when investors will begin to get their money back in addition to any profits.
Venture Capital Fund Returns
Venture fund investors may make a return on their investment when an exit event occurs; i.e., an IPO or merger/acquisition. In the event that a profit is made off the exit, the fund will also receive a cut of the profits, or “carried interest” in addition to the annual management fee. The standard fee for a venture fund is a 2% annual management fee plus 20% carried interest. Usually, the fund charges the management fee for a minimum of five years (which would equal 10%).
For our venture funds, we generally charge a 0.5% annual management fee and 10% carried interest. If there is a payout, MicroVentures only receives the carried interest after investors have recouped their investment in its entirety. When there is a distribution for one of our funds, they are done in cash. After the liquidity event occurs, distributions begin the next quarter.
There are many variables that can affect return, including risk profile and the industry itself, which means there isn’t really a standard to aim towards for gross internal rate of return, anything in the positive is a gain.
Choosing a Venture Capital Fund
When choosing a venture fund, there are three main things you should consider:
- What your goals/interest are
- The reputation of the fund manager
- Time horizon
To start, consider what your investment goals are and what industries you’re interested in. As mentioned earlier, there are funds for all kinds of specific interests. For example, if you’re looking to primarily invest in tech, it would make sense to find a fund that specializes in tech investments. Conversely, if you’re looking to diversify, you will want to seek out a fund that aims to make broader investments. Once you have a general sense of what you’re looking for and you have found a fund that suits those needs, do your due diligence on the fund manager to confirm that they are reputable and that they have the necessary industry experience. Lastly, consider your ideal time horizon. An early-stage fund may have a time horizon of seven to 10 years, while a late-stage fund may be around four.
Benefits of Investing in a Fund
Like other funds, there are many reasons why investors find the fund structure to be advantageous. Their simplicity, opportunity to diversify, and professional management make them an attractive option for DIY investors willing to assume higher risk while seeking higher returns.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.