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Venture capital funds

Venture capital funds are a type of investment fund. Venture capital funds own fractional and whole interests in other companies. These other companies are called portfolio companies. What types of companies venture capital funds invest in? Venture capital funds seek companies that have enormous potential for future revenue growth and profits. Therefore, venture capital funds search for companies that operate in the most cutting-edge industries of the day. If one were living during the beginnings of the automobile industry or the airline industry, venture capital firms would be investing in automobile companies or airline companies. Today, venture capital firms seek investments in software, biotechnology, clean energy and other areas. The ultimate investment for a venture capital fund is the earliest and strongest company operating in a new and potentially profitable industry – the fastest and strongest boat running in the fastest current.

Here is a small list of modern companies that received venture capital investments early in their operating history: Ebay, Amazon, Yahoo, Google, and Chinese Search Engine Baidu.

Venture capital fund taxonomy
Seeking innovative companies is a general characterization of venture capital funds. Venture capital funds can be categorized in even more specialized ways. Some funds concentrate on one specific industry. For example, a venture capital fund might concentrate only on finding companies in the software industry. Another fund might concentrate on companies that are in a specific “stage” of their development and that require some minimum amount of revenue in order to be considered as a portfolio companies. Other funds might concentrate on a particular geographical area such as Silicon Valley, California, or Z-Park in Beijing, China.

Who invests in venture capital funds?
Typical investors in venture capital funds are private pension funds, public pension funds, insurance companies, and wealthy individuals and families.

Structure of venture capital funds
Venture capital funds are structured as limited partnerships or limited liability companies. The general partner – usually a management team – makes the investment decisions for the fund. The limited partners act as passive investors and provide capital for the fund.

The venture capital management team
Because venture capital funds are so specialized, management expertise is required. A management team is usually comprised of individuals with extensive business and finance experience. It is common to find ex-technology executives on the management team. Many successful entrepreneurs start venture capital funds as a retirement hobby.

Finding portfolio companies
Venture capital funds find portfolio companies in several ways. Most of the time an entrepreneur in need of capital for expansion will approach the management team of a venture capital firm. The entrepreneur will submit a business plan and meet with the venture capital fund management team. If the venture capital fund is interested, the entrepreneur will sell a portion of ownership in his company. After an agreement is reached, the entrepreneur’s company is now a portfolio company in the venture capital fund.

The ongoing relationship between the venture capital fund and the entrepreneur
During the relationship between the venture capital fund and portfolio company, a member of the venture capital fund management team will usually sit on the board of directors of the portfolio company. The board member will offer strategic and financial guidance to the entrepreneur. The first goal of the venture capital fund is to grow the revenues of the portfolio company. Later, the venture capital company will guide the sale of the portfolio company.

Portfolio company sales
Portfolio company sales happen in one of two ways: 1) through the sale of the portfolio company to another company – a private sale; or 2) through an initial public offering of the portfolio company called an IPO.

Returns from individual investments can be huge
The profits from the sale of a portfolio company can be huge. Sometimes an investment into a young innovative company can return many thousands of percent. For example, imagine that a venture capital fund buys a 20 percent ownership in a young company for 1,000,000 dollars. This price values the entire company at 5,000,000 dollars. If the company is sold privately for 50,000,000 dollars the 20 percent stake will be worth 10,000,000 dollars, which is a return of 1000 percent.

Investing through a venture capital fund spreads risk
Though it is true that some venture capital investments net huge returns, other venture capital investments are complete losses. In other words, the individual investments within venture capital funds are highly skewed. The highly-skewed nature of individual venture capital investments makes it imperative to invest in venture capital through the collective investment scheme of a fund. Within a fund, investors’ money is pooled and allocated across many companies, thus spreading the risk.

Venture capital funds have high average returns
When the few big investment gains are averaged with other gains and losses within the fund, venture capital fund returns are higher than those of other equity-type investments. The average return for the ten year period ending in June, 2009 is 14.3 percent. In the year 2008, venture funds returned minus1.6 percent, while the NASDAQ returned minus 21.4 and the Standard & Poor’s 500 returned minus 22 percent for the year ended September 30.

Costs to investors
The fees of a venture capital fund are usually 1% to 2% of assets under management and 20% to 30% of the capital gains of the fund. In most cases, before investors are charged for capital gains, the fund must achieve a minimum rate of return. The minimum rate of return is sometimes called a hurdle rate.

Requirements for investing in venture capital funds
Venture capital fund investing requires a substantial monetary and time commitment. Funds have a high minimum investment: typically between 250,000 to 1,000,000 Euros. The length of time for a commitment to the fund – lock-up time – can range from three to ten years.

Conclusion
Venture capital funds are a great way to add early-stage business ownership to a wealth portfolio. By purchasing an interest in the venture fund, the fund investor gains ownership interests across multiple early-stage companies. Because required minimum investments are high and lock-up periods are long, venture capital funds are only available to wealthy investors.