How venture capital investment works

So by now, you should have a good grasp on how your personal equity works. You understand your grant, you know the type of equity you were given and you know what to expect when it comes to things like vesting, exercising, taxes, all that stuff. 

And that’s great, but there’s one big piece of the puzzle that’s still missing. And that missing piece is how the larger venture capital industry works. So whether you know it or not, we are all operating in the venture capital ecosystem. 

What is the venture capital ecosystem? It’s any startup, any funder, or any consumer of any product that was funded by venture capital. If you downloaded an app, if you bought something from a new company, you probably interacted with the venture capital ecosystem. So in this final lesson, we are going to step back and zoom out and look at this venture capital ecosystem as a whole. What happens when a company raises money and what does that mean for you?

So, there are a bunch of different ways that a private company can raise money. And in this universe, we say “raise capital” instead of “money.” 

In the startup universe, there are two types of ways to raise capital: equity financing and debt financing. We are going to focus on equity financing. And within this system, there are several different types of entities that can give a company capital or money. The main types of investment entities that we are going to talk about here are angel investors, venture capital funds, and a unique type of fund entity called a special purpose vehicle. 

Sidebar: What is a fund? A fund is an entity that pools other people’s money together into a single entity and invests in companies. There are two main types of investors, angels, who are investing their own money, and venture capital investors who are investing other people’s money from a fund.

OK. So depending on the fund type involved in the fundraise, there will be different terms and conditions associated with that capital (money). These terms and conditions ultimately trickle down to the shareholders, which could be the employees or the investors. 

So the big question is: What are the terms and conditions associated with raising capital from an investor? This all depends on the type of fundraise your company is doing. And there are traditionally two main instruments. The first is called a convertible instrument and the second is a priced round. 

So our traditional understanding of how startup investments work is a lot like the show “Shark Tank.” The people on stage will give startups a million dollars in exchange for 20% of the company. Simple transaction: Money goes in, in exchange for shares. It’s easy to follow. And that is exactly how a priced round works. It’s called a “priced round” because the investor is paying a clear, defined price for a certain percentage or number of shares in the company.

But in the early stages of company development, it’s actually very common for companies to fundraise using a different kind of instrument. And this is called a convertible instrument. You can think of a convertible instrument like an IOU: An investor gives money to Startup A today, but Startup A does not give the investor any shares yet. Instead, Startup A promises the investor two options. The startup will pay the investor back with interest at a future point in time, which makes it much more like a loan. Or the company grows, and at a certain point in the future, they want to raise a priced round. When they actually have a price on their company, then they promise to convert that note into shares of the company. So the investor who invested via a convertible instrument now owns equity in the company. 

So you might be wondering: Why would a company do this—right? If you give me money today, then what difference does it make if I give you shares a year from now? It’s a good question. And there are actually a bunch of reasons for this kind of transaction, but the main one you need to know is control. 

All investments are about control. And when an investor takes a percentage of a company, the investor typically gets a certain level of decision-making power and influence over the direction of that company. But in that very beginning stage, it’s typically too early to make all of these decisions about control. Why? Because the founders are still figuring out their product-market fit, meaning: Do their target customers want to buy what they’re selling? And these founders need more freedom to move toward developing their vision. 

So a convertible instrument allows the founder to hold on to their shares for now and promises the investor that in the future, those shares will convert the instrument into an even friendlier amount of shares and equity. It’s sort of a “thank you for being patient and coming along with me for the ride at this very early stage of the company.”

The point of all this is to give you an understanding of who is investing at a company at each new stage of company growth. So if you look back at the two types of investments we just talked about—a convertible instrument and a priced round—the convertible instruments tend to be used for very early funding rounds like the pre-seed and seed stage rounds. Again, these are the rounds where the company has not yet achieved product-market fit, i.e., selling their product in a repeatable way to their target customers. 

On the other hand, priced rounds tend to be used when a company gets some traction and really starts growing. Priced rounds are when the value is set by the investors. And the value would be set when you have something to value like revenue. And those rounds tend to be lettered like Series A, Series B, and C, and so forth. 

Depending on the round, the type of investor that’s putting money in will be different. So investors are specialized by stage. You’ll have investors that only focus on the pre-seed stage, seed stage, Series A. Why? Because all of those companies are at different stages of development and require different levels of capital, different expertise, and different levels of control. 

So now, let’s take a deeper look at each investor type. If you remember the last lesson, we talked about accredited investors. These are typically high-net-worth individuals who are considered sophisticated and financially educated—at least enough to be able to invest in non-public companies aka startups. 

These individuals, who are investing in startups on their own, are referred to as angel investors. And in the earliest stages of a company, like the pre-seed or the seed rounds, it’s pretty standard for founders to seek funding from their friends, their family, or other people in their network. All of these people would be considered angel investors if they invest their funds directly into the company, as opposed to pooling their funds together and investing through a fund. 

Keep in mind, these very early funding rounds are usually being done using riskier instruments like a convertible instrument. So that typically means angel investors are taking on the most risk of any investor. 

So if an angel investor is a single person investing their own money, then you can think of a venture capital firm as an entity that pools together capital from other people and invests it on their behalf. 

Let’s take a look at an example. Iris played the startup game well, and now she wants to start her own venture capital firm. In other words, Iris doesn’t want to invest individually. Iris has instead developed an investment thesis, which is her strategy for investing in companies that she believes will change the world. 

And she doesn’t have enough capital as an individual to really execute on this thesis. Instead, she wants to pool other people’s capital because she sees an opportunity big enough to be able to absorb millions and millions of dollars, which is more than she wanted to invest as an individual angel. 

She starts a venture capital firm and she names it Iris Ventures. (Getting real creative here.) She decides to raise that capital from a whole bunch of other people. She will manage the process of investing their money for them. 

If Iris wants to do this, there are a few steps she’ll need to take before she can even think about raising money from other people. The first thing she’s actually going to want to do is work with a bunch of advisors to make sure she understands the legal and compliance requirements of all of this stuff. Then, she’s going to want to start an LLC.

Why? Because in the event that something goes wrong or someone wants to sue her, she wants to limit her personal liability. So she spins up an LLC. And let’s see that company right here. This is the first of three entities that Iris is going to set up. 

This entity, the LLC, entity number one, is called the general partner. And since she’s the leader of the firm, she is what we call a member of the general partner. 

The second entity that Iris is going to create is called the management company. Think of the management company as the brand, or the headquarters, of the firm. The management company does all kinds of things. It employs all the employees of the firm. It pays for the office space, the software, any events they go to, the pens they buy. The management company does exactly what it sounds like—it manages. Think of it like an umbrella that sits over the top of everything. 

So now Iris has set up her management company as the umbrella. She’s also set up the general partner as the specific company that will control her fund. 

The third entity that Iris is going to create is the fund. And I want to make a note here. This fund is not like the other companies. It is not an LLC. Instead, the fund is a different kind of entity called a limited partnership. A limited partnership enables Iris to enter into a legal relationship with all of the people who are going to invest in her fund. Those investors are called limited partners. And Iris is the general partner. 

Let’s go back to that concept of liability we talked about in the beginning. In this partnership, we have two kinds of partners: 

– Limited partners who invest into the fund—and they’re limited because they have limited legal liability and they also have limited control over what the fund does. They are investing because they trust Iris. They don’t actively make the investment decisions. They are investing because they trust Iris to make the investment decisions. 

– Iris, on the other hand, is the general partner because she and her team are making the investment decisions. And together, they form this partnership. And that’s what the fund entity is. It’s a partnership.

OK. So at this point, just to recap, Iris has formed three entities. She’s created the general partner, the management company, and the fund. All the pieces are in place and it’s time to go out and actually raise some capital.

Iris now sets out to fundraise. First thing she does is set a target of $200 million for her fund. And she has to go out and find the investors who are most likely to invest in her fund. These investors can be accredited investors like we talked about, or qualified purchasers like endowments, foundations, pension funds, corporations, family offices. And as we discussed, these investors are called limited partners or LPs. 

Now we have this big pool of cash with $200 million in it. This pool of $200 million is the fund. 

OK. So quick recap: Iris is the general partner of the venture capital firm called Iris Ventures. She has raised a $200 million fund from a bunch of investors who become limited partners when they sign on and invest in the fund. All LPs who invest in Iris Ventures, Fund 1 will agree to and sign a limited partnership agreement, which governs how the fund will run, how profits will be paid out, and pretty much every aspect of the fund itself. And now that there’s capital, Iris can go and invest that into a bunch of different private companies. A typical fund will invest in anywhere from eight to 25 companies. And all of these companies become part of the firm’s portfolio.

So when you hear someone say, “We are an Iris Ventures portfolio company,” what they’re talking about is that Iris Ventures invested in them. Over time, Iris’ firm might raise several funds. This very first one is Iris Ventures Fund 1. If she’s successful, she’ll have the opportunity to raise Iris Ventures Fund 2, Fund 3, Fund 4, and so forth. 

But there’s still one last question we haven’t answered: How does Iris make money from all of this? Right here, this is where the two final ingredients come in: management fees and carried interest. These are the two pillars of Iris’ business model as a venture capital investor. 

The management fee is exactly what it sounds like. Basically, Iris is going to set up a separate entity called the management company. And this management company has a whole bunch of employees and infrastructure to set up and manage the fund. Meet with the startup founders, do a bunch of market research, figure out the ultimate question: Where’s the best place to invest all of this money?

The management company employs all the employees of Iris Ventures. And the way that Iris pays for her employees, her office space, her software is by charging a management fee on the committed capital that she raised. So we’re talking about a $200 million fund right here. And usually this management fee is around 2%. So for this fund, since it’s $200 million, the management fee will be 2% of that or $4 million per year. This $4 million pays for all of those salaries, rent expenses, maybe a PR firm, and anything else that Iris Ventures needs to run well. 

The other way Iris and the general partner make money is through a thing called carried interest. Or if you want to speak the industry lingo, call it “the carry.” This is essentially Iris’ cut of the overall profits of the fund. So when the fund makes money, Iris first has to pay back all of her LPs for their original investment. But then whatever money the fund makes on top of that, the general partner gets to keep a certain percentage.

Usually the carry is set around 20%, but it can vary from firm to firm. So in our example, let’s say the fund does really well. And that’s a total return of $1.2 billion. Iris is first going to take 200 million of that and pay back the LPs who put their money in. And from the remaining one billion, she’s going to take a cut of 20% or 200 million. The remaining 800 million gets distributed to the LPs. 

If you’re ever in conversation with an investor and you hear the phrase “two and 20,” it’s typically referring to the pay structure that we’re talking about here: 2% management fee and 20% carry. 

There’s one last type of investment fund I want to tell you about, and it’s called a special purpose vehicle. And its special purpose is to invest in a single asset. Unlike a venture capital fund, which will invest in eight to 25 companies over the course of its lifetime as a fund, an SPV is designed to invest in one company, one opportunity. That’s it.

Think of it like a fund that’s spun up specifically to purchase equity in one special company. You might raise an SPV if you don’t have a fund yet and you’re trying to build your track record as an investor. You may have lots of great access to individual opportunities to invest in startups and you can raise a special purpose vehicle and bring along limited partners to just invest in that single opportunity. Or you might already have a venture capital fund, but you want to do one deal that’s outside of your investment thesis. So let’s say you invest in enterprise software only, but you encounter a consumer company that you just love. You would raise an SPV to be able to invest outside of your fund into that company, investing in one thing.

You did it. You started from zero and you made it all the way to the end. So pat yourself on the back, you have officially finished Equity 101 by Carta. The learning doesn’t stop here. It’s just the beginning. And with the tools you now have, we hope you can set off on your own equity journey, feeling confident and ready to take control of your financial future. Know your worth.