Venture Capital structures refer to the organizational models adopted by venture capital firms to manage and direct their investments. These models or “structures” dictate how a venture capital firm raises, allocates, and manages the funds it invests in startups with high growth potential. From traditional funds to venture builders, special purpose vehicles, and outsourced funds, each venture capital structure boasts unique strategies and characteristics, tailored to distinct objectives and market dynamics. In this article, we explore these four venture capital structures, examining their mechanics, advantages, disadvantages, and use-cases to illuminate the dynamic, multi-faceted nature of the venture capital landscape.
There are four structured commonly used with venture capital:
- Traditional Funds: These firms collect funds from partners and invest across multiple startups, planning for a profitable exit.
- Venture Builders: This type of firm creates and manages companies and funds internally, fostering business growth from within.
- Special Purpose Vehicles: These are simplified funds that concentrate primarily on a single deal, offering lower fees and carry than traditional funds.
- Outsourced Funds: These platforms allow part-time or amateur investors to establish venture capital funds, simplifying the investment process and reducing administrative work.
A single venture capital firm may have one or more of these structures in place.
Traditional venture capital firms accumulate funds from limited partners, such as high net worth individuals, family offices, and endowments. They allocate these funds to invest in nascent, high-growth companies, intending to exit their investments after a few years via a sale or initial public offering (IPO), aiming for substantial returns.
Traditional Funds represent the professional venture capital businesses that most people are familiar with. These funds are utilized by experienced investors and financial institutions to support promising startups, with the hope of seeing substantial returns in the future.
A traditional venture capital firm procures $200 million from its limited partners. The firm channels this capital into ten early-stage companies, each obtaining $20 million. Five years later, one company floats an IPO. The venture capital firm offloads its stake for $100 million, securing a sizable profit.
- Diversification: These firms spread risk by investing in a myriad of companies.
- Expertise: They provide beneficiary companies with their extensive experience and expansive networks.
- High Risk: The risk of startups failing is considerable. Unprofitable exits can lead to significant losses.
- Long-term Commitment: It may take many years to realize returns on investments, requiring patience from investors.
Venture builders, also known as “startup studios” or “startup factories,” operate companies and funds. These firms generate new businesses internally from their operations, rather than investing in external startups.
Venture Builders are an ideal choice for domain experts with a clear vision. They use this type of venture capital to fund and launch companies they are passionate about, providing them with full control and the ability to implement their expertise directly.
A venture builder formulates an idea for a novel software service. It mobilizes an internal team to develop and market the product. After fruitful trials, the firm launches the service and funds it using their in-house venture capital firm. The firm retains a significant stake in the newly launched service, giving it a higher degree of control and reducing risk.
- Control: These firms wield more control over the startups they nurture, mitigating certain startup investment risks.
- Hands-on Approach: Their hands-on nature permits the execution of successful frameworks across various startups.
- Limited Diversification: Venture builders may lack investment diversification due to their focus on internally developed companies.
- Resource Intensive: Creating a startup from scratch demands significant resources and time.
Special Purpose Vehicles
Special Purpose Vehicles (SPVs) are simplified funds that pool investments typically for a single, specific investment deal. They offer smaller fees and carry, functioning similar to a traditional fund but with a narrower focus.
Special Purpose Vehicles are a rapid response tool in the venture capital arsenal. They are typically used to pool resources swiftly and invest in hot deals that are trending in the market and promise quick returns.
A venture capital firm spots a late-stage startup requiring substantial investment. The firm establishes an SPV, amasses $50 million from a variety of investors, and channels the fund into the startup. If the startup flourishes, the investors share the returns.
- Targeted Investments: SPVs enable focused, one-off investments in companies or projects.
- Risk Isolation: As distinct legal entities, SPVs isolate financial risk to themselves, shielding the parent company.
- Lack of Diversification: An SPV concentrates on a single investment, which may lead to a lack of diversification.
- Work Intensive: Establishing and managing an SPV requires considerable effort for just one investment.
Outsourced Funds simplify venture capital. They are great for beginners and part-timers. Platforms such as AngelList enable individuals to try out venture funds as consultants. This setup is ideal for part-time investors.
For those looking to dip their toes in the venture capital industry, Outsourced Funds provide the perfect stepping stone. These funds enable beginner investors and part-time enthusiasts to get started in venture capital, offering a guided and streamlined process.
An individual new to venture capital wants to support early-stage startups. He turns to AngelList to create an outsourced fund, raising $5 million in capital commitments. The fund, managed and operated by AngelList consultants, invests in various promising startups. This structure allows the individual to participate in venture capital without worrying about administrative complexities.
- Accessibility: Outsourced funds democratize venture capital, allowing beginners and part-time investors to participate.
- Support: The fund management and administrative tasks are taken care of by experienced consultants, guiding new investors through the process.
- Dependence: Fund operators must rely heavily on the platform, which may expose them to potential risks and limitations.
- Limited Control: Due to outsourcing operational control, investors may not have the same level of influence as in a traditional venture capital fund.
In addition to the types of venture capital structures, there are Specialty Funds. These are alternative investment vehicles that deviate from the traditional venture capital model. However, most of these are not venture capital funds but rather types of private equity or debt funds.
Revenue-Based Funds provide capital in exchange for a percentage of ongoing gross revenues. The payments continue until a predetermined return multiple is reached. Search Funds are set up by entrepreneurs who raise a pool of capital to fund the search for a promising company to acquire and manage. Receivable Funds provide capital based on the accounts receivable of a company. Secondary Funds focus on buying existing stakes in venture-backed companies from early investors looking to exit.
Interestingly, the lines between venture capital and other forms of private equity are blurring. A growing number of private equity funds are branding themselves as venture capitalists. This trend speaks to the increasing complexity and diversity in the startup financing landscape.
From Traditional Funds, Venture Builders, Special Purpose Vehicles, to Outsourced Funds, the venture capital landscape is dynamic, diverse, and complex. Understanding the distinctions between these types of firms can assist entrepreneurs in making informed decisions about potential investments. By exploring each model’s examples, advantages, and disadvantages, the complex world of venture capital can become more accessible and manageable.
Carry: Also known as carried interest, it is a share of the profits of an investment paid to the investment manager in excess of the amount that the manager contributes to the partnership.
Endowments: Funds donated to institutions or foundations, where the principal amount remains intact, and only the income or interest earned on it is used.
Family Offices: Private wealth management advisory firms that serve ultra-high-net-worth investors.
High Net Worth Individuals: People who have significant financial wealth and investible assets beyond the value of their primary residence.
Initial Public Offering (IPO): The first sale of stock by a company to the public. A company can raise money by issuing either debt or equity through an IPO.
Limited Partners: Investors in a limited partnership, who have limited liability and typically do not have management control.
Private Equity: Capital investment made into companies that are not publicly traded.
Receivable Funds: A type of funding where capital is provided based on the accounts receivable of a company.
Revenue-Based Funds: Investment funds that provide capital in exchange for a percentage of ongoing gross revenues until a predetermined return multiple is reached.
Search Funds: Investment funds set up by entrepreneurs who raise a pool of capital to fund the search for a promising company to acquire and manage.
Secondary Funds: These funds specialize in buying existing stakes in venture-backed companies from early investors looking to exit.
Specialty Funds: These are alternative investment vehicles that deviate from the traditional venture capital model. They may be types of private equity or debt funds.
Venture-backed Companies: Companies that have received funding from venture capital firms. These companies are typically high-growth startups.
Venture Builders: Also known as “startup studios” or “startup factories,” these firms generate new businesses internally from their operations, rather than investing in external startups.
Special Purpose Vehicles (SPVs): These are simplified funds that pool investments typically for a single, specific investment deal.
Outsourced Funds: These funds allow part-time or amateur investors to establish venture capital funds, simplifying the investment process and reducing administrative work.