Back to Basics

Let’s start with how venture funds are set up, and where the money for venture investing comes from.  Venture investors usually raise money in the form of funds, often referred to as LP/GP funds (LP = Limited Partners, GP = General Partners).  Venture funds can range from $25 million up to more than $1 billion, and really there is no limit.

These venture funds raise their money from institutional investors.  Institutional investors are VERY large investors with lots of money (typically an institutional investor will have $250 million to $100 billion plus), think college endowments, public pensions, corporate funds, insurance companies, and high net worth individuals.  These intuitions are known as the LPs (limited partners) in the funds, because they invest their money, but make no direct decisions related to the actual investments.

The venture funds have a team of professionals, known as the GPs (general partners).  These professionals are the ones that will decide how to invest the millions of dollars raised, but not without some rules.

First, the venture funds don’t actually get all the money upfront, but the institutional investors hold on the money until a couple of days before the venture funds need it.  Each time a venture fund needs money, they issue a “capital call” to the institutional investors.  The venture fund is only allowed to issue capital calls for three to five years from the time they start investing money, which means the full amount of the fund (between $25 million and more than $1 billion, remember?) has to be completely invested in the first couple of years!

After three to five years, the next three to five years are known as the “harvest period”.  During this time the venture funds investments are hopefully growing from small companies to really big companies.  But there is no more money going in or out of the fund (kind of, there are other things happening, but for simplicity we will stick with this story).

At the end of the “harvest period”, the venture funds start the “liquidation” of the portfolio.  This results in the venture fund selling all of their businesses; through taking a company public or having another company buy their company (e.g. Google buying Nest Labs for $3.2 billion).   As they sell their business, they are hopefully making lots of money for the institutional investors and returning all of the money.  This whole process, from closing a fund through full liquidation takes 10 years to 12 years (the funds are structured where they are not ALLOWED to last longer than that often).

So, in about 500 words, there it is.  The entire system of venture funds and institutional investors made simple.  Get it?

I don’t get it…

Let’s try to make things make a little sense of these things through some real examples.  Let’s start with who invests in the venture funds and go from there.

Here’s a perfect example: Andreessen Horowitz (known as A16Z) is raising a new venture fund, on the larger size, of $1.5 billion.  Since this isn’t their first fund that means that they already have a bunch of intuitional investors, which have previously invested in A16Z’s funds.  Those investors (many of which are publicly known through a filing with the SEC called a Reg-D) include the Stanford University Endowment (an endowment, obviously), Bloomberg (a public company), and Accolade Partners (a fund-of-funds investor, think a really big private mutual fund).  Each institutional investor will pledge a portion of the full $1.5 billion A16Z is looking to raise.  Simple example, if Stanford commits $150 million (10% of the full fund), every time A16Z needs money, Stanford’s capital call will equal 10% of the total money being requested.

Once A16Z closes their fund, they will start to make investments in new companies.  Using an example from last month, A16Z invested $20 million in Teespring.  In order for A16Z to actually get the $20 million needed to invest in Teespring, they needed to issue a capital call to the institutional investors (such as Stanford, Bloomberg, etc.).  Those institutional investors sent money to A16Z in order for A16Z to invest in Teespring.  In our past example, Stanford would be responsible for sending $2 million to the Teespring investment (10% of the $20 million capital call).  For the next three to five years, A16Z will support Teespring and help Teespring grow, hopefully selling the business for lots of money.

Speaking of lots of money, A16Z is pretty good at making it.  Like back in October 2012, when they sold a company called Silver Tail Systems for $2.1 billion, after investing an estimated $22 million in June 2011.  When this happened, A16Z has to distribute that cash back to their institutional investors.  Because they invested about $20 million, and sold it for $2.1 billion, those investors are very happy.  Now A16Z didn’t necessarily make 10x their money (I’ll explain that later), but they definitely made a lot.  In our example, Stanford would receive their 10% of the total distributions!  Because those investors are very happy, they will invest in A16Z’s new fund today.

So, with a few examples, this is hopefully a little clearer as to who gives whom money, and why.  These basics apply really to all private equity and venture capital funds, and like anything in life, there are exceptions and special cases; but the vast majority of funds are set up this way.  We’ll get into some more interesting specifics soon, but I felt we needed baseline to start from.