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Definition A venture capital firm (VC firm or venture firm) is a collection of legal entities formed for the purpose of generating substantial returns for its investors by investing in high-risk companies that have yet to prove that their business models work and are sustainable in the marketplace.
Definition A venture capital fund (or venture fund) is a legal entity, created by—but separate from—a VC firm, that pools money from outside investors and directs investments to companies seeking capital. Venture capital funds are typically structured as partnerships.*
It is helpful to understand venture firms as institutional investors to differentiate them from other kinds of startup investors, such as angels, and when contrasting institutional venture rounds from angel rounds.
confusion Venture capital firms and venture capital funds are not the same thing. A venture firm is the perpetual legal entity under which many individual venture funds can be raised and closed over time. For example, Hunter Walk and Satya Patel run Homebrew, their venture firm. In a post on the Homebrew blog, Hunter and Satya announce that they’ve raised $50M for “Homebrew Fund II,” the second venture fund raised and managed by Homebrew.
controversy Venture capital firms and institutional investors also are not technically the same thing, although many refer to venture capital firms as institutional investors. Both make investments from pooled resources, but institutional investors typically act as intermediaries, rather than investing directly in companies. For example, an institutional investor may become a limited partner in a venture capital firm.* Traditional examples of institutional investors include investment banks, endowments, hedge funds, and insurance companies.*
A new VC fund is kind of like a startup, just one that writes checks instead of code.Hunter Walk and Satya Patel, Partners, Homebrew*
Stage of Investment
Venture capital firms and funds are semi-formally divided into stages of investment that reflect the maturity of the businesses they invest in. Many VC firms focus on particular stages, and a few focus on many stages. The types of VC firms are inextricably linked to the terminology of rounds.
important Keep in mind that none of these terms are standardized in any legal or universally recognized way.
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Over time, venture firms may invest in startups outside their typical stage range. A firm could be in the seed stage for a few years, investing in seed-stage companies, but later, they might raise a larger fund to invest in later-stage companies. NextView Ventures provides data on how investment stages shifted from 2002 to 2016.*
Additionally, many firms may continue to invest in a company that has performed well over time, even if that company has matured outside the VC fund’s typical range.
Pre-seed and seed stage investments. The term pre-seed is relatively new,* likely coming into use around 2015.*
Pre-seed firms invest in pre-product companies that do not yet have a product or service ready for client or consumer use. These companies might have a lightweight prototype, or nothing more than an idea on a napkin. Pre-seed investors write checks ranging from $50 to $500K.
confusion Not everyone has embraced the pre-seed term, which some consider overly specific and constraining. Until recently, a company’s earliest venture capital investors were simply called seed stage firms. Some firms that consider themselves seed-stage will invest pre-product, all the way up to the last check before a Series A round.
Early stage investments. Some firms that call themselves early stage will invest all the way from pre-seed to Series A, while others will only do seed-stage deals.
important If a firm describes itself as early stage, it’s worth asking how many deals the investors have done in pre-seed, seed, and Series A in the last year, to get an idea of where their sweet spot is.
Mid-stage investments. These firms invest at or right after a company reaches product-market fit, which is usually around Series A or Series B rounds.
Late stage or growth stage investments. These firms invest in companies that have reached product-market fit. Companies usually spend the money they raise at this stage to help them get to IPO.
Type of Investment
DefinitionGeneralist firms, thematic firms, and thesis-driven firms are types of venture capital firms that differ in how they choose companies in which to invest. Generalist firms invest in companies in almost any sector (healthcare, FinTech, automotive, et cetera) or business (data aggregation, human computer interaction, marketplaces, et cetera) within the stage the firm typically invests in. Thematic firms invest in companies operating in particular sectors or working on particular types of problems.* Thesis-driven firms are a narrower version of thematic firms, investing only in companies that fit a hypothesis about where an area of focus is heading.*
confusion Classifying venture capital firms according to these three types isn’t always straightforward, and firms can drift between types—particularly between thematic and thesis driven—over time.
Examples of thematic firms are Psilos, which invests in healthcare companies; The Water Council, which focuses on clean-water based opportunities; Kapor Capital, which invests in tech companies serving low-income communities and communities of color; and Backstage Capital, which funds companies founded by entrepreneurs from underrepresented backgrounds. An example of a thesis-driven firm is Union Square Ventures, whose thesis as of April 2018 is “USV backs trusted brands that broaden access to knowledge, capital, and well-being by leveraging networks, platforms, and protocols.”
Some funds take a geographic focus, like Chicago Ventures, which focuses on tech companies in Chicago and the Central region of the U.S., Drive Capital, which focuses on the Midwest; and Steve Case’s seed fund Rise of the Rest, which focuses on companies outside the “big three” VC markets of Silicon Valley, New York, and Boston.
Figure: The Geography of U.S. Venture Capital Investment
Source: National Venture Capital Association*
Roles at a VC Firm
In the process of raising venture capital, you’ll interact with a lot of different people at VC firms. When you stalk them on LinkedIn or see a title in their email signature you don’t recognize, you can revisit this section to better understand what that individual is likely responsible for at their firm. This will help you know what kind of relationship you might have with them and what questions they can answer for you.
Typically, some individuals have the ability to make an investment unilaterally (that is, write a check), while others might need consent or consensus among senior partners before making a deal. Some staff may focus only on sourcing deals, analysis, operations, or other tasks besides investment decisions.
Most venture capital firms have some form of hierarchy, with associates and analysts at the entry level and managing directors and partners near the top, but not all of them follow this formula. What’s important to know is that some people can make a decision to invest, and others cannot. When you’re starting to fundraise, you should try to get a meeting with someone who has the authority to make an investing decision. Some venture firms prefer to observe a process where every company, unless it’s exploding with growth, meets with an associate or principal before a decision-maker.
important Do not assume that structures and titles used at one firm will be the same at another, even if they seem similar. Roles, titles, and decision processes vary significantly. The list that follows gives an indication of common meanings of these titles, but it’s generally wise to ask a given individual about their role and confirm whether they can invest unilaterally. Given the ego involved in titles, some investors may inflate their influence. The best way to handle this is to ask investors the following:
Can you walk me through the process of how a deal gets done at your firm?
Do individuals at the firm have the ability to write checks unilaterally? If so, who has that ability?
If not, are decisions made by majority vote or unanimous approval? Who has the power to vote in either circumstance?
Be wary of investors who get prickly when you go down this line of questioning. It’s perfectly reasonable for a founder to expect to get answers to these questions.
caution Although awareness of seniority is key to understanding the operation of VC firms, watch out for any tendency to devalue more junior partners. It is both good karma and good business to treat everyone you work with, including junior associates, with respect. As a founder, doing otherwise can be rude and is almost certainly not in your own interest. Every person at a firm can have influence, and a more junior partner may have more time to give you as they search for the risk that will propel their own career. On the other hand, despite being unable to actually execute any deals and having the primary job of collecting information, some junior partners or lower-level individuals may present themselves as having more autonomy than they do, which can be maddening to deal with as a founder.
Managing directors (MDs) and general partners (GPs). Individuals with these titles are almost always the ones who make the final decisions on investments and sit on boards. As a rule, no firm will have managing director and general partner titles. A GP title carries formal legal liability, while an MD title does not. Many firms, in lieu of the legal distinction around the GP title, have opted to simply use the title partner.
Partners. The partner title has a lot of variability. In some firms, especially those that forego using managing director or general partner titles, the partners are the most senior employees who have the authority to write checks. On the other hand, some firms have eliminated hierarchy from their titles and refer to all employees as partners. In between, some firms use the partner title more broadly to describe individuals with influence over decision-making but who are not necessarily able to write a check.
Principals and directors. Individuals holding one of these titles will rarely be able to make an investment decision without approval from a more senior person at the firm. In some cases, associates may be promoted to principal before being promoted to partner. While they may not be able to write checks, individuals with these titles wield more influence on a deal than analysts or associates.
Associates and analysts. These persons generally take on a wide range of supportive functions at a venture firm.* Many associates are hired out of top MBA programs, but some firms prefer to hire individuals before they’ve gone to business school. Associates may stay at a firm for two to three years and then go on to work at a portfolio company, start a business, or get their MBA, and in some cases, they’re promoted within the firm.*
Platform. Many venture capital firms employ a variety of individuals with specific subject matter expertise, in an effort to add value beyond capital to portfolio companies. Stephanie Manning Cohen, the director of platform at Lerer Hippeau, lists talent, business development, content, marketing and communications, community and network, operations, and events as six of the common buckets that platform roles typically fall into.
Venture partners and operating partners. At some firms, venture partners and operating partners have a similar standing to those of principals and directors, with the venture partner title acting similarly to a junior partner title. In other cases, venture partners may be experienced angels or entrepreneurs who work part-time for the firm, similar to EIRs.
Entrepreneurs in residence (EIRs). Every now and then, a venture capital firm will extend an offer to an entrepreneur to work out of the firm’s offices while they develop their next idea. Usually, there’s some form of a handshake agreement that the founder will let the venture firm invest in their company, should they decide to raise. Venture firms sometimes ask EIRs for their opinions on potential investments.
Scouts. In 2012, Sarah Lacy at Pando broke a story about Sequoia Capital giving cash to well-connected individuals, called scouts, via a limited liability company that doesn’t appear to be affiliated with the firm.* Most scouts don’t have enough money to invest in companies on their own; otherwise, they probably would do just that. By 2017, The Wall Street Journal reported that Accel Partners, CRV, First Round Capital, Flybridge Capital Partners, Founders Fund, Index Ventures, Lightspeed Venture Partners, Social Capital, and Spark Capital all had scout programs up and running.*
Student VCs. A small group of VC firms have begun hiring students on a part-time basis to source deals on college campuses, and some have even started student-focused funds. Prominent student-run VC firms are First Round Capital’s Dorm Room Fund and General Catalyst’s Rough Draft Ventures.*
Limited Partners: Investors’ Investors
In many cases, individual partners at venture firms invest their own money into each fund. All VC firms require senior members to invest their own money into funds they raise and eventually deploy into companies. In some funds, the total amount invested by the partners can be as small as 1%, but you rarely see more than 5%. Most of the money a VC firm invests has itself been raised by investors outside the firm, called limited partners. (It really is turtles all the way down.)
DefinitionLimited partners (LPs) provide capital for venture firms, similarly to the way VCs fund startups—they invest in companies in exchange for equity (or part ownership of the business). The vast majority of money a VC invests is money raised from LPs, who often manage sums in the billions. LPs invest in a range of different asset classes, each with a different profile of risk and expected returns.
Venture capital is one of the riskiest asset classes for an LP, which means the right investment into a VC firm can generate the greatest returns for LPs. LPs only invest a small portion of the money they manage into venture capital firms. For example, Harvard’s endowment was worth $39.2B in 2018, and it may invest a small percentage of that into a number of different venture firms, say, 5–10%.* But the word small can be misleading, given that 5% of a $39B endowment is almost $2B.
DefinitionLimited partnership agreements (limited partner agreements or LPAs) are contracts that investors sign with venture capital firms to become limited partners. These agreements outline how the relationship will operate, including how the capital will be invested and distributed back to the partners of the firm.*
Some LPAs or side letters with LPs restrict investors from investing in controversial industries,* such as recreational cannabis or pornography.
DefinitionAnchor LPs are limited partners that invest early into a venture fund, set the terms of the investment, and in some cases get preferential terms.
A venture firm’s LPs can be any of the following:
Family offices. These are money managers employed by wealthy individuals to ensure their money is safe and growing.
Fund of funds. These LPs take money from other LPs and invest it in multiple venture capital funds.
Insurance companies. With large numbers of individuals or companies paying premiums into an insurance company, these companies can quickly accumulate vast sums of cash that they want to make sure grow.
Public or corporate pension funds. Retirement funds for government institutions and companies.
Sovereign wealth funds. Government institutions that invest a country’s surplus capital.
University and non-profit endowments. Universities and non-profits collect and hold donations in endowments. The institution that’s set up to manage that endowment is tasked with making sure the money grows at least beyond the rate of inflation.
Wealthy or high-net-worth individuals (HNWIs). These are individual investors who are investing their own money.
caution In 2018, many founders—especially those with SoftBank as an investor—found themselves in an ugly spot in the wake of the murder of Saudi journalist and Washington Post columnist Jamal Khashoggi when they realized that Public Investment Fund of Saudi Arabia was one of their investor’s LPs.* Unsurprisingly, in the same month as the Khashoggi assassination, Fred Wilson penned a post on how VCs should question whether it’s right to take money from certain LPs.
Exits and Returns
When founders and investors disagree about scale or speed of growth, it often comes down to what VCs expect in returns (and need to deliver to their LPs), and how they chase them. In this section, we’ll explain how VCs generate returns through exits. To learn how VCs measure returns before and after a company’s stock has become liquid, visit Appendix B.
Definition In finance, a return is the profit an investor receives from an investment. Returns can be expressed as absolute sums (“the fund returned $30M to investors”), multiples of the original investment (“the investment returned 3X”), or as percentages (“the fund boasts a 300% return”).
Limited partners expect venture capital firms to generate net IRR (internal rate of return) in the neighborhood of 20% annually—no small task when you’re talking about tens or hundreds of millions or even billions of dollars. Venture capital funds aspire to generate 3X net IRR. Most firms end up in the 2X category, 5X is the breakpoint for a top-tier fund, and 10X is exceptional (and rarely repeats in the next fund).
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