• November 2019
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How Do Venture Capital Firms Turn a Profit?

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Anyone can have a great idea. But few individuals and companies are given the opportunity to allow great ideas to blossom into reality. Endless potential hurdles keep valuable ideas from becoming realized; regulatory restrictions, intellectual property protection issues and design challenges are just a few examples. But perhaps the greatest obstacle standing in the way of most great ideas is money. To create and design “the next big thing,” individuals and companies need funding. And unfortunately, funding for unrealized ideas is often not readily accessible. Let’s take a look at how venture capital financing works.

Fortunately, venture capital companies exist primarily to aid individuals and companies in funding their potentially marketable ideas. Oftentimes, startups, new businesses and entrepreneurs could not be successful without aid from venture capital companies. Similarly, venture capital firms could not be successful without the ideas enterprising individuals and companies generate. While the venture capital model exists to support the development of potentially lucrative ideas, it only succeeds because providing this support is often quite profitable.

How Venture Capital Firms Operate

At its most basic, the venture capital model provides high risk financing to individuals, companies or organizations with the hopeful expectation that this financing will provide a lucrative return on its investment. Within most venture capital firms, both general and limited partners contribute to the operation. Limited partners provide capital to be invested, while general partners decide which opportunities are worthy of the firm’s investments. It is worth noting that limited partners often consist of endowments, pension funds, insurance company funding, hedge funds, etc. Venture capital firms generally do not significantly invest the personal funds of individual partners.

When an individual, company or organization needs funding, it is usually a general partner or partners who will ultimately agree to support that need, draw up the terms of the arrangement and remain in contact throughout the venture capital funding process.

Turning a Profit

In an ideal arrangement, both the company seeking funds and the venture capital firm itself will turn a profit over time. Companies with successful ideas or products profit off of these commodities directly. Venture capital firms generally profit in two ways off of these enterprising companies.

First, firms usually charge annual management fees. These fees help to cover the cost of operations and ultimately amount to a small fraction of a particular fund’s commitments.
Second, venture capital firms make money when their investments pay off. When an investment turns a profit, a “carry” is charged. At its most basic, a carry represents a specific percentage of profit made.

Say that an enterprising startup wants to create a revolutionary social media platform. In order to develop, market and sustain that platform initially, it requires funding. A venture capital firm sees the potential in this new platform, so it provides the startup with necessary capital, subject to an agreement outlining the specifics of its management fees and potential carried interest. Once the platform is hailed as a success and begins turning profits, a portion of those profits (along with the required management fees) are paid to the venture capital firm. The firm is then free to reinvest whatever portion of its share it chooses either back into the enterprising company or into other opportunities.

It is worth noting that oftentimes, venture capital agreements grant firms an ownership interest in companies affected by those agreements. As startups, companies and organizations become increasingly profitable, the venture capital firms that have invested in those businesses reap more profit based upon the percentages and/or ownership interests agreed to initially.

Third, if and when a company goes public or is sold, venture capital firms generally turn a significant profit on their shares in their investment company or their ownership interest in that business.

Seeking capital or interesting investments?

Venture capital is a risky business. It is precisely because untried startups and/or ideas are often not able to become successful without aid that they need the assistance of venture capital firms. Unrealized opportunity is potentially very lucrative, but it is also potentially draining. Even excellent ideas can fail to turn a profit if market conditions and other factors are not perfectly aligned. It is for these reasons that both enterprising companies and venture capitalists benefit from informed counsel before entering into an agreement.

Knowledgeable counsel can help to ensure that both businesses with potentially lucrative ideas and venture capital firms seeking their next investments succeed. And because neither venture capital firms nor their investments can succeed long-term without the other, it is important that both potential investors and businesses seeking funds obtain knowledgeable counsel before signing binding legal documentation.

LawTrades has significant experience with all aspects of the venture capital model. Whether you are seeking funding or are looking for potentially lucrative investments, our legal team can guide you throughout the process and can better help to ensure that your partnerships lead to success. And remember, seeking a consultation does not commit you to any specific action but it will help to guarantee that your ultimate decisions are well informed.