For the average Canadian investor, the venture capital industry is an inaccessible, mysterious black box where Ferrari driving fund managers roll the dice in search of the next “unicorn” emerging from all of our collective Snaps, Likes and Tweets. Stories of instant (though sometimes unsuspecting) millionaires being minted off the latest tech IPO add to the mystique of early stage tech investing. The reality is a little more mundane, where conservative institutions such as pension funds, endowment plans and family offices have long allocated portions of their portfolio into carefully laid out investment theses put forward by individuals with enough credibility to attract millions of dollars worth of backing.
Simply put, venture capital (“VC”) firms use private capital to invest in high growth companies, typically in exchange for equity or instruments convertible into equity. The need for this source of capital arose from the lack of traditional funding (e.g. bank loans) available to entrepreneurs with little collateral. Such businesses carry a high level of risk and uncertainty unsuitable for bank loan portfolios, and as a result, are in need of risk capital that is willing to invest based on long term prospects rather than short term fundamentals. Alternatively, a growing business may require a large infusion of capital to rapidly expand its operations or to gather market share. This is where a venture capital firm comes in.
Definition
Using private capital to invest in high growth companies, typically in exchange for equity or instruments convertible into equity. Participating in a venture capital fund gives investors indirect ownership in a diversified portfolio.
Participating in a venture capital fund gives investors indirect ownership in a diversified portfolio of high potential technology startups. Though many startups will fail, the bet in investing in a fund is that the gains generated by that fund’s winners will more than offset the capital invested into the failures. Investors rely on the ability of the fund manager to not only select the right entrepreneurs and business ideas, but also to actively manage and nurture their portfolio companies into successful exits. Contrary to mutual fund managers, who can make a healthy living by collecting a percentage of assets under management regardless of performance (i.e. the management fees subsumed in the much maligned MER), the compensation of the venture capital fund manager is heavily tied into his or her ability to generate positive returns for the fund’s investors.
Most VC funds are structured as limited partnerships in Canada. A fund manager’s first job is to raise investment capital for the fund, typically from high net worth individuals and/or institutional investors (i.e. pension funds and endowments) who become limited partners (“LP”s) of the fund. The fund manager(s) will usually create a separate corporate entity as the general partner (“GP”) of the partnership, which acts as the operator and manager of the fund’s activities. The goal of the GP is to deploy its capital into rapidly growing companies with the hope of earning a high level of return through an eventual sale or public offering of its investee companies. Most VC funds have an expected life of 7-10 years, where the managers are busiest in the first 1-4 years finding and evaluating new portfolio companies and deploying capital into them. Rather than collecting all of the money up front, larger VC funds will often seek “commitments” from its investors, and only collect the money through capital calls over the life of the fund. Smaller funds, on the other hand, will typically collect all of the committed capital up front.
Key Insights
Traditionally, the GP (i.e. the fund manager) is compensated through a combination of a “management fee” and a “carried interest”. The management fee is an annual percentage of the funds committed to the VC that is used to pay the salaries and overhead of the GP. Expenses associated with creating and operating the fund, however, will normally be borne by the LPs (that is, is over and above the management fees). Most VC firms will charge a management fee ranging from 2% to 2.5% per year though some firms charge no fee at all. Larger funds may also see the fee decrease after 4-5 years and/or only apply to invested capital at that point.