Venture Capital and Equity Ownership

Equity, in simple terms, is the worth of something. When an individual “owns” equity, it means they own a financial interest in a business.

 Venture capital (VC) is a type of investment model where investors pour capital into fast-growing companies that show exceptional growth potential. This capital can come from a variety of sources including high-net-worth individuals, investment banking firms, and other institutions. A VC firm typically invests in companies that show a promising potential for profits. In exchange for their financing, investors generally demand a percentage of “equity ownership.”

 Investors expect this return over a span of 7-10 years. After the lifecycle of a VC fund, the equity is either laid out on a public stock exchange or sold back to the client company. Now that you know the answer to the private equity vs. venture capital question, it’s time to dissect how both go hand in hand throughout a fund’s lifespan.

Equity’s Role in Ensuring Subsequent Funding Rounds

Equity is the lifeline of a funding round.

 Startups journey across various funding rounds to raise money from investors. The goal of a funding round is to raise capital so that a portfolio company can financially fuel its operations and growth. 

A funding round is when a startup sells a portion of the equity of their company to investors. In return for the capital that investors supply, they gain a percentage of ownership in the company. How much equity an investor owns depends on the capital they invest. Those who invest a larger capital stand to gain more equity ownership. 

The same process repeats each time a company steps into a funding round. From fueling its operations to opening new offices – the money raised via funding rounds helps startups scale quickly and efficiently. 

If the portfolio company performs well, its equity becomes more valuable. The result is a higher profit for investors and faster growth of the portfolio company. Equity investment also fuels all funding rounds so startups don’t suffer from financial obligations that come with a traditional funding route (such as loans). 

How Much Equity Do You Give Up in Each Round of Funding?

How much equity does a startup give up during each funding round? 

There is no hard and fast rule for this. Funding rounds vary from company to company. What’s common, however, is that founders end up giving away a portion of ownership and control of their business to investors. The factors that determine how much equity a founder must be given up include:

·         The valuation of a company during investment. Before investing in a startup, a VC firm runs a comprehensive company valuation. This valuation reveals certain critical investment factors such as a company’s track record, management, growth prospects, potential for profits, and market size.

·         The amount of capital investors shell out. The more money an investor invests, the higher the equity they demand in return. 

While funding rounds come in all shapes and sizes, the base equity value (according to the “traditional” VC fund model) that a startup owner gives up is between 10-20%. Giving more than 25% of equity up to an investor could prove risky for most portfolio companies. This is because funding doesn’t always just stop at one round. Startups must go through multiple rounds until their company reaches its zenith and giving up too much equity could mean diluting the overall control a founder may have over it.  

What Do Venture Capitalists Get in Return?

A VC fund pours capital into a startup and monitors the investment throughout the fund’s lifecycle until a startup enters what is known as a “liquidity event.” This event could either unfold in the form of an acquisition or IPO that generates dividends for investors. 

VC investments often experience power law distribution. This means that out of a portfolio of many companies, only one (or a handful) of companies generates outsized returns for the entire investment. According to data, a startup experiencing a seed stage funding round has a 2.5% chance (or a one-in-40 shot) of bringing outsized returns. This makes investing in early funding rounds extremely risky. 

But when a portfolio company does succeed, the returns can be massive. Read on to understand what the general partners (GPs) and limited partners (LPs) stand to gain as per their roles and financial contributions over the fund’s lifespan. 

How Much Equity Do Venture Capitalists Get

Regardless of what specifics a VC deal unfolds, the logic of the deal is more or less about: giving investors the opportunity to make additional investments ( that is, if a startup performs well) while providing ample downside protection. 

In a typical portfolio company deal, a VC fund will stand to gain 40% equity ownership by investing a sum of $3 million. However, this value can vary widely for different startups. When a liquidation event occurs, investors are given the first preference to both recover their initial capital and take a bite out of the profits. Should a venture fail, it is the investors who are given the first preference to claim the assets of a startup. 

Regular Compensation for General Partners

A general partner is someone who controls all decisions related to a VC fund. For their services, they receive compensation in the following ways:

·         Management fees. GPs charge a 2% annual management fee for managing a VC fund. This fee acts as compensation for the GP’s services and the resources they allocate for the fund’s operational costs.

·         Carried interest (or carry). Carried interest is a form of performance bonus GPs stand to receive when a VC fund generates results. This interest typically sums up to 20% of the fund’s total results. GPs receive their carry only after the capital that limited partners have invested is returned back to them. 

How Limited Partners Profit from Venture Capital

The role of a limited partner in a VC fund is to invest capital. Unlike general partners who do most of the heavy lifting in managing a fund, the role of a limited partner is more or less limited to the money they invest. Once LPs pour in the money, they simply sit back and hope for their investments to bring returns. Other duties of LPs involve understanding the terms of a VC agreement and seeking updates on how the fund performs. After fees and carried interest, the limited partners (LPs) of the fund take home the remainder of the returns. In most cases, this remainder sums up to 80% of the total returns. This sum is then distributed among investors based on the amount they invest during the fund’s lifespan.