GURUKUL > How VCs work - Part 2

In this Gurukul, lets look at how a VC Fund works and how VCs make money.

As mentioned in the last gurukul, VC funds raise money from investors and invest it in companies. Typically, the VC fund is akin to a close-ended mutual fund and has a life of between 7 to 10 years. This is called the Fund Life. Every VC fund has a focus and an investment strategy that details the amount of money they will typically invest (say $2m) at what stage of a company (viz. seed, early, late etc), and the sectors of investment (e.g. internet, IT services etc). Based on these and some other parameters, VC funds invest their money in companies for the first half of the Fund Life. The second half is usually reserved for finding exits for their companies (i.e. going IPO, finding acquirers etc). At the end of the Fund Life, the companies would have either succeeded (i.e. would have returned a profit to the fund through a sale to a larger company or through the IPO) or they would have failed and been written off.

VCs usually make money in three ways: management fees, carried interest, and stock price appreciation after a company goes public. Management fees are fees charged for managing the fund and take care of salaries and all administrative overheads. This is usually between 2% and 3%; VCs get to participate in the profit generated in the fund usually to the extent of 20% (some of the wildly successful Silicon Valley firm charge 30%) – this is the real payoff. Investors get to keep 80% of the profits. Appreciation from the public stock from companies going public before funds were distributed to the investors also provide additional profits. However, in many cases, many of the investors insist on distribution immediately before/after an IPO.

Usually, of the 10 investments made by a VC, about 5 will be in the write-off/living dead category. Of the remaining 5, a maximum of 2 will return stupendous returns (very successful IPOs and post IPO performances) while 3 will provide attractive returns (perhaps through acquisitions). Of course, in these heady times (till the recent crash) the definitions of stupendous and attractive would have undergone re-valuations northwards! Thus, the ones that provide stupendous returns will not only have to make up for the significant losses, but provide for a large part of the fund profits. The risks are significant and VCs therefore look at achieving significant upsides. This in turn means that the market opportunity being addressed has to be large and growing and the ability of the team to execute has to be beyond reasonable question.

One of the most widely used and simple metrics used by VCs to describe their investment returns is the cash-on-cash (COC). So if you hear an investor saying he expects a 10 times (also referred as 10x) return in 5 years, the COC return will be equal to 10 after a 5 year holding period