The main difference between venture capital and traditional private equity is the compensation structure. While traditional private equity is more generous, venture capital has no such rules. This structure is aimed at helping entrepreneurs turn their ideas into real businesses, rather than merely paying a few rich people to invest their money in the startup. While most entrepreneurs start their companies as employees of large companies, the compensation for their work is not always so generous. As a result, many entrepreneurs end up as shareholders in their companies, earning little or no money.
To obtain funding for your company, venture capitalists will conduct due diligence on your business. The firm will then send you an offering document detailing the amount of funding, your percentage of equity, whether or not you will be required to serve on the board, and other terms and conditions. This can take several months, so be patient. Getting a referral from a financial professional is often the easiest way to gain attention from VC firms. Keep in mind that VC funds are looking for a partner in your business and want to be sure that your team is capable of delivering on the promises.
VCs must make returns to keep their investors happy. The S&P 500 returns 7% a year, but venture capitalists must produce gains of 500 to 800 basis points above that. If you fail to deliver on that promise, you risk losing your reputation and making it difficult to raise more money. To avoid this, you must invest in high-performing startups. These will keep your LPs happy and still give you a generous carry.
Venture capital companies are typically run by a few partners. These partners raise capital by putting up between one and two percent of the total size of the VC fund. Venture capitalists are not employees of the firm, but are expected to source investment opportunities for the fund and receive compensation only if they are involved in a deal. In return, they are compensated with equity in the company that becomes publicly traded. That’s how this investment model works: the entrepreneur gets paid for the product they created.
VC investors usually invest in a company for a long period of time. It typically takes five to ten years for a startup to mature. In this timeframe, it’s not possible to pull out your money until the startup is more stable and profitable. In addition to that, venture capital funds often have a ten-year lifespan. This gives the entrepreneur ample time to see their investments through without feeling under pressure. That allows for greater efficiency in the company’s management and operations.
The return on VC investment is a power-law curve. The funds managed by the most successful firms tend to make the biggest returns, while those in a lower-growth sector do not receive much help. As a result, the investment flows reflect this predictable pattern. The long tail consists of funds that have not generated the industry average returns. This means that entrepreneurs in low-growth segments usually have trouble attracting VC funds. Then again, if your product has a great chance of making it big, a VC will support it.