What Is Venture Capital? How VC Funds Work
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Venture capital (VC) is money from professional investment funds that buy equity in young, high-growth companies, usually in return for preferred shares. The people who run the fund invest other people's money, not their own, and they are paid partly in fees and partly in a share of the profits. That structure explains most of what venture investors do: why they chase very large outcomes, why they push for fast growth, and why a good but modest business is often a poor fit for them.
This article covers how a VC fund is built, how the people running it get paid, why returns follow a power law, how a typical investment moves from first meeting to exit, and how VCs differ from angels and corporate investors. It describes common US practice. Terms vary by fund, firm and country.
How a VC fund is structured
Most venture funds are set up as limited partnerships. The National Venture Capital Association (NVCA) puts it simply: venture firms typically create a limited partnership with the investors as limited partners (LPs) and the firm itself as the general partner (GP). Cooley GO, a law firm's startup resource, defines the structure as a general partner who manages the business and has unlimited personal liability, and one or more limited partners who have limited liability but cannot participate in management. It adds that institutional venture funds in the US are typically organized as limited partnerships or LLCs.
So there are two roles:
- General partners (GPs) are the investors you meet. They pick companies, sit on boards, and decide when to sell.
- Limited partners (LPs) supply the money and stay out of day-to-day decisions. The NVCA lists public pension funds, corporate pension funds, insurance companies, family offices, endowments and foundations as examples.
LPs don't wire all their money on day one. They commit a total amount, and the fund draws it down as needed. In the NVCA's words, the money is taken from limited partners as the investments are made through "capital calls".
A firm usually runs a series of funds over the years (Fund I, Fund II and so on). Each fund is its own partnership with its own investors, and it's a separate pool from the last one. When founders say a firm "has a new fund," that's what they mean: fresh money with a fresh clock.
Fund life and the investment period
A venture fund has a finite life. The standard partnership agreement lasts for ten years, with extensions that in practice mean the partnerships generally run even longer. Institutional Investor reports that most fund agreements include the option of at least two one-year extensions, which take fund life to 12 years. Its article also says the median fund takes slightly longer than 14 years to wind up, and that only about 7 percent liquidate within a decade. The ten-year figure is how funds are marketed, not how long money is tied up.
Within that life, funds usually split into two phases:
- Investment period. The early years, when the fund writes new checks to new companies. Funds commonly slow or stop new investments as this phase ends, depending on the agreement.
- Harvest period. The later years, when the fund supports existing companies, makes follow-on investments from reserves and works toward exits.
Reserves matter more than founders expect. The NVCA notes that an initial funding of a company will cause the venture fund to reserve three or four times that first investment for follow-on financing. A fund that invests $1 million in a seed round may have set aside several million more for later rounds, which is why a fund's size shapes the stage it invests in and the size of check it can write.
The fund's clock is the founder's clock too. Investors need exits within the fund's life, and that shapes what they'll back. The NVCA says the payoff comes after the company is acquired or goes public, and puts the average mix of exits at about 15 percent through IPOs and about half through mergers and acquisitions.
How VCs get paid: management fee and carried interest
GPs earn money in two ways.
The management fee is a yearly charge that covers salaries, rent, travel and research. It's paid whether or not the fund makes money.
Carried interest ("carry") is the GP's share of the fund's profits. It's paid only if the fund returns money to LPs, and the partnership agreement sets how and when it's calculated.
The common shorthand is "2 and 20": a 2 percent annual management fee and a 20 percent performance share. The US Securities and Exchange Commission (SEC) described that shorthand in a 2022 enforcement action against a venture manager that had advertised its fees as the industry standard "2 and 20". The SEC said the phrase would lead investors to believe the manager would collect a two-percent management fee during each year of its funds' 10-year term, and separately collect a 20-percent performance fee. That's a useful reading of what the phrase normally means. It's also a reminder that the label is a convention, not a rule. Actual funds set their own terms, and LPs diligence them.
Here is a hypothetical example with round numbers, meant only to show the mechanics:
- An LP group commits $100 million to a new fund.
- The fund charges 2 percent a year. To keep the arithmetic simple, assume the fee is calculated on the full $100 million for all ten years. That is $2 million a year, or $20 million over the fund's life.
- The fund eventually returns $300 million to LPs and GPs combined.
- At a 20 percent performance share, and ignoring the details of how a real agreement calculates profit, the GPs' carry would be about $40 million (20 percent of the $200 million gain).
Real agreements differ on what the fee is charged against, whether it steps down after the investment period, and how profit is measured. The point of the example is the incentive. Management fees pay the GPs to keep the lights on, and carry is where the real upside sits. That's why GPs care so much about finding a rare very large winner.
The power law: why VCs fund what they fund
A venture portfolio isn't a basket where each company contributes equally. A few investments produce nearly all the return, and most produce little. Paul Graham of Y Combinator wrote that in startup investing effectively all the returns are concentrated in a few big winners. His example: the companies Y Combinator had funded were worth around $10 billion at the time, and just two of them, Dropbox and Airbnb, accounted for about three quarters of it.
This pattern has direct consequences:
- VCs need outliers. A fund can't return its capital through a pile of decent outcomes. It needs a few companies that grow many times over. A business that doubles in value and then plateaus is a fine result for founders and a weak one for the fund.
- Missing a winner costs more than backing a loser. A failed investment loses at most the check. A passed-on outlier is a loss of unbounded size, so VCs often prefer a bold company with a small chance of greatness to a safe one with none.
- Market size becomes a screening test. If the best realistic outcome is a $50 million sale, the math rarely works for a fund that needs a few billion-dollar outcomes. That's why investors ask about market size so early.
- Pressure to grow. Because the fund's return depends on a few companies, the GPs push those companies to grow fast and raise again. The result is a founder-investor mismatch that bootstrapped vs venture-backed startups explains from the founder's side.
How a VC investment works, step by step
The process varies by firm, but most deals follow a similar path.
- Sourcing. Deals arrive through founder outreach, referrals, accelerators and demo days, and the investor's own research.
- Screening. An associate or partner takes a first call. Many firms pass here, and most founders never hear more than a short reply.
- Partner meetings. The partners debate the team, market, product and traction.
- Term sheet. If the firm wants in, it sends a non-binding term sheet covering price, board seats, and rights. The investor that sets the price and terms is the lead investor.
- Due diligence. The firm verifies the claims about the business, legal position and financials. See startup due diligence.
- Closing. Lawyers finalize documents, the money is wired, and the investor takes shares and often a board seat.
- Post-investment. The firm advises, makes introductions, helps hire, and decides whether to follow on in later rounds from its reserves.
- Exit. The company is sold or goes public, and proceeds flow back through the fund to LPs, with carry paid to the GPs.
Each round sells part of the company, which is the subject of equity dilution. The stage names (seed, Series A, B, C) are covered in seed round and Series A, B and C funding.
VC vs angel vs corporate venture capital
| Venture capital fund | Angel investor | Corporate venture capital | |
|---|---|---|---|
| Whose money | LPs' pooled capital | The individual's own money | The parent corporation's balance sheet or a dedicated fund |
| Typical stage | Seed to growth, depending on the fund | Often the earliest outside money | Varies, often tied to the parent's strategy |
| Goal | Financial return to LPs, which pays carry | Return, plus interest in the founder or sector | Financial return and strategic benefit |
| Decision process | Partners vote, with a fund-wide strategy | One person, quick decisions | Corporate approvals, can be slower |
| Follow-on capacity | Reserves built into the fund | Usually limited | Depends on the parent's budget |
| Fund clock | Finite fund life | None | Set by the parent |
An angel investor invests personal funds, so there are no LPs to answer to and no fund clock. That's why angels can back a company a fund wouldn't, but they rarely have the reserves to follow it through later rounds. Corporate venture capital comes from an operating company that wants a financial return and also something strategic, such as access to new technology or customers. Founders weigh that mix against potential conflicts, especially if the corporate investor competes with their future acquirers.
What founders should take from this
- Know the fund, not just the partner. Ask how large the fund is, when it was raised, how much is reserved for follow-ons, and whether it's still in its investment period. A fund near the end of its life behaves differently from a new one.
- Fit matters more than fame. A fund that needs very large outcomes will push for them. If your plan is a durable, profitable company of moderate size, a different funding path may serve you better.
- Terms outlast the relationship. Preferences, board seats and consent rights stay with the company after a partner leaves the firm.
- This is general education. It isn't legal or financial advice, and securities and fund rules differ by country.
Key Facts
- Most venture funds are limited partnerships: GPs run the fund and LPs supply the capital, per the NVCA.
- LPs commit capital that is drawn through capital calls as investments are made (NVCA).
- The standard venture partnership agreement lasts ten years, with extensions that in practice make funds run longer (NVCA). The median fund takes slightly longer than 14 years to wind up, according to Institutional Investor.
- "2 and 20" means a 2 percent annual management fee plus a 20 percent performance fee, as the SEC described it in 2022.
- Graham reports that Dropbox and Airbnb accounted for about three quarters of the value of YC's funded companies when he wrote the essay.
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